DeFi will never die, why?

By Donovan Choy

Source: Bankless

Why DeFi Will Never Die

Resilience, antifragility, transparency.

There is an undisputed premise here: people are often ignorant, greedy, hopeless, and incapable of navigating a complex world.

So how should we design economic systems around this fact?

Economic systems that can be called resilient accept these sober realities and build themselves around these less than ideal but real circumstances, rather than beyond them.

Resilience does not depend on bull market prices, but on the ability to adapt to changing market conditions without the need for outside intervention from regulators or benevolent billionaires.

In finance, resilient systems need to answer affirmatively several key questions:

1. Can the system effectively eliminate bad debts?

2. Does it inhibit and phase out unsustainable business models, or support them?

3. Can it achieve the above two points before systemic risks accumulate?

4. When systemic risk arises, can it be resolved with minimal active management and negative spillovers?

The proposition of decentralized finance is closely related to how it can achieve these goals better than its centralized counterparts.

From the tokenomics design of a protocol, to its day-to-day treasury management, and the health of its balance sheet: everything in DeFi can be transparently observed on the blockchain and monitored in real time.

It allows us to see where the big players are betting and where risk is concentrated.

Mainstream media often describes DeFi as the "Wild West of finance," but the reality is far less lawless than the metaphor suggests. DeFi is full of self-regulatory mechanisms.

Self-regulation of decentralized finance

Let’s take Lido Finance and Solend’s recent attempts at self-regulation as examples:

Lido controls approximately one-third of the circulating supply of ETH. Its centrally held ETH has prompted researchers at the Ethereum Foundation and Vitalik himself to sound the alarm that Ethereum may face a centralization threat. A lot of debate ensued, and then a governance proposal to self-limit ETH deposits on the liquid staking protocol. This governance proposal failed, but Lido's validator set was further decentralized by adding 8 new validators.

Solend, the largest lending protocol on Solana, faces a more immediate threat. A single whale holding a huge margin position ($170 million) could trigger a catastrophic liquidation event if the price of SOL continues to drop and affect the entire chain.

In response, Solend's developers presented a series of governance proposals to the community, first proposing to take over the whale's account and perform a secure liquidation, but eventually reaching a solution that introduced a new rule that limited the borrowing limit to $50 million ($108 million borrowed by the whale).

Lido and Solend are likely not out of the woods yet, but both governance incidents illustrate something unique about DeFi.

Transparency in blockchain network rules and on-chain activity enables internal and external stakeholder communities to rally around issues of common concern and work toward solutions. In both cases, stakeholders sounded the alarm and engaged each other in deep technical discussions before it was too late — not after.

People take stupid risks, systems get maliciously attacked, things go wrong. The question is what game rules would best handle this. TradFi's answer to this is, "the government will pass a law".

To this, DeFi's answer is: "We will let the code decide".

The Decline of Centralized Finance

In contrast, consider the dominoes of crypto banks that have fallen over the past month.

At the heart of the fiasco was Three Arrows Capital, a "too big to fail" venture capital fund. 3AC faced massive liquidations ($400 million) in over-the-counter trades during the market crash in mid-June, the earliest sign of its liquidity problems.

3AC’s instability quickly exposed a series of high-risk shadowy transactions conducted by crypto banks with depositors’ money behind the scenes. BlockFi provided $1 billion in overcollateralized loans to 3AC, while Voyager Digital provided a further loan of approximately $670 million.

Although the latter is relatively safe with a capital ratio of 4.3%, what led to its current predicament was the risky decision to pool more than twice its total capital with a single hedge fund.

Of course, venture deals happen across the financial spectrum, not just crypto banks. The point here is not the existence of risk, but how the system manages and deals with risk.

Unlike DeFi, the centralized balance sheets of crypto banks preclude the ability for netizens to investigate independently.

These over-leveraged, high-risk trades are only discovered when the boiling water overflows the pot - too late. There is a liquidity crisis going on among crypto banks that is being made public only because doing so is legally necessary to get your funds back.

The main problem with centralized crypto banks is that most of their transactions are bilateral off-exchange transactions that take place behind closed doors and are only known to insiders.

The DeFi aspect of centralized players

The problems with Celsius were first exposed when signs of insolvency emerged in a series of on-chain loans. These include 17,900 WBTC deposited by Celsius in the Maker vault [Celsius increased collateral to avoid liquidation due to Bitcoin price drop (the loan was fully paid off on July 7)], 458,000 stETH deposited on Aave (stETH price Deviation from ETH), and more assets collateralized on Compound and Oasis.

Thanks to the exposure of its on-chain data, cryptocurrency watchers were able to examine some of the signs of the impending storm.

Sure enough, withdrawals were halted just a day after the Celsius CEO denounced speculation that Celsius was on the brink of bankruptcy. The alarm bells sounded a bit late, but there is comfort in the fact that the damage could have lasted much longer had it not been.

Another example is Terra's implosion in May. Signs of this disaster were completely transparent from the start, with liquidity first starting to dry up rapidly on Curve. As my colleague Ben said:

“On Saturday, May 7th, the UST peg came under pressure for the first time because $85 million in the USTw-3CRV Curve pool was swapped from UST to USDC... This large transaction finally shook the liquidity providers in the pool Confident, they quickly withdrew their 3CRV, causing the pool balance to drop to 77% UST and 23% 3CRV on May 8.”

What follows is the most centralized and explicitly anti-DeFi aspect of this affair.

As millions of Terra investors began to panic, Do Kwon famously tweeted: "Deploying more capital - stable mates" and Terra's centralized entity, Luna Foundation Guard, began selling 15 $100 million in Bitcoin to maintain the peg to its algorithmic stablecoin.

These are not subject to the rules of the smart contract and are effectively a promise. By that time, Anchor was flooding out of funds, and Terra was finished.

In the case of 3AC, analysts knew that its balance sheet was unhealthy due to on-chain evidence that 3AC lost $560M from locked LUNA in May and evidence that they closed their stETH position in June . The mystery of 3AC's insolvency is incomplete, but some fragments allow plausible speculation.

In the end, as these companies quickly approached bankruptcy, DeFi loans became the main repayment object because it was the only option, while high-risk, high-leverage closed-door bilateral transactions between CeFi platforms were brought into the legal system.

Why? You can fight for a better deal in court, but you can't argue with a smart contract.

All of these examples make a compelling point: Celsius, Terra, and 3AC all have a foot in the on-chain world, which is the key to discovering that their unsustainability may be exposed before the apocalypse approaches. This won't completely avoid or prevent crises like Lido and Solend - but if they were fully DeFi native, they could.

epilogue

To reiterate the previous point, the correct starting point for social science is that people tend to be greedy, stupid rogues. Scottish Enlightenment philosopher David Hume argued that truly resilient political-economic systems should be built around this fundamental fact of human nature:

...assuming that every man is a scoundrel, and that all his actions have no purpose other than his own gain. We must govern him in this interest, and in this way cause him to cooperate for the common good, notwithstanding his avarice and ambition.

The strength of DeFi is that no naive assumptions are made around this simple reality. It takes human shortcomings and designs ruthless smart contracts around it. Ryan said it well in his blog last week: In DeFi, code is the liquidator and settlement engine.

At the time of the 3AC crash, major DeFi protocols such as Aave, Compound, and Maker were functioning well by performing liquidations and clearing bad debt. In June 2022 alone, Compound ($9.9M), Aave ($2.6M) and Maker ($49M) have liquidated up to 9 figures without any issues.

When bad things happen, it means no negotiations behind closed doors, no taking issues to the courts, no lobbying regulators, just the simple rules of immutable smart contracts that we agree to abide by.

This is what a resilient economic system looks like.

This is DeFi.