CeFi Models Have Stumbled Exposing Flaws, While DeFi Has Worked, As Expected
Amidst the severe contraction in cryptocurrencies and the near or actual insolvency of prominent crypto-infrastructure companies (BlockFi, Celsius, Voyager), there is talk that DeFi is in decline and its foundational structure is weak. That observation is misguided, ill-informed, and outright false. The problems we are witnessing began with a steep, sudden, and broad market decline in all cryptocurrencies which triggered problems in “algorithmic” Stablecoins like Terra Luna
Getting the Nomenclature Right: TradFi, CeFi, and DeFi
Traditional Finance or TradFi is built around an “intermediated” model, where retail and institutional customers go through intermediaries (banks, insurers, asset managers, brokers, exchanges, custodians, etc.) to execute the four basic financial activities: payments, borrowing/ lending, investing, and insurance. Centralized Finance or CeFi also operates on a centralized finance model just like traditional finance, except that it involves cryptocurrencies and digital tokens. Just like in TradFi, the CeFi model relies on an individual identity for underwriting and managing risk through intermediation, which is the source of most of the problems plaguing CeFi models in the current market.
In sharp contrast, Decentralized Finance or DeFi is built on a fully decentralized, blockchain-based financial structure with smart contracts and programmable code replacing intermediaries’ role in underwriting, executing, and managing the risk of financial transactions prevalent in traditional finance and CeFi. The Smart contracts in DeFi are immutable and controlled via on-chain governance. Notably, the parameters (what is deemed to be acceptable collateral, or the actual interest rate or yield paid) in DeFi agreements can be set by the Community, but not the core risk parameters, which are programmatically embedded inside the protocol. For a platform to be deemed pure DeFi, the settlement layer must be fully decentralized. True DeFi models must possess three essential characteristics: 1) the financial assets in the model must be controlled by the user, 2) no single entity can unilaterally alter the execution of a transaction, and 3) no single entity can unilaterally change the execution of the protocol. Every change must be approved by the Community and reflected on the Blockchain.
The truth is those true DeFi models (exemplified by companies like Aave
Putting the Last Few Months of Crypto Events in Perspective
The crisis kicked into high gear in April 2022 as Bitcoin
This caused widespread loss of confidence, and the contagion spread to all market participants. One of the firms highly leveraged to the Terra-Luna debacle was Three Arrows Capital (3AC), which had accumulated massive exposure by acquiring leverage from leading crypto prime brokers, including Celsius, Voyager, and BlockFi. The 3AC founders declined to return margin calls from these prime-broker lenders.
To protect their customers and prevent a “run on the bank,” the Crypto lenders put up gates on customer withdrawals, creating panic and forced selling on other venues that were still operating, further decimating market confidence.
The common problem has been CeFi companies taking Crypto deposits from customers, promising above-market yields, depositing this Crypto into DeFi, and utilizing massive leverage. This strategy worked very well as Crypto prices kept rising during 2019-2021 and VC/PE investors kept financing these CeFi companies at ever higher valuations. But as crypto prices precipitously declined and pushed Stablecoins to de-peg, the weak business models and excessive leverage of CeFi companies got exposed, thrusting them into insolvency.
Importantly, almost all crypto-related companies in crisis today are companies with CeFi models, not DeFi. The continuing turmoil in Crypto is centered around CeFi companies characterized by centralization, weak business models, low transparency, lack of regulatory oversight and supervision, misrepresentation, and outright fraud. In contrast, the DeFi infrastructure has performed remarkably well due to its decentralized, programmatic structure with almost no human involvement or judgment. This explains why none of the major DeFi companies are facing insolvency or under undue financial stress.
One of the most revealing developments from this mayhem is that despite their dire financial situation, CeFi companies (eg, Celsius, Voyager Capital) have been repaying their loans to DeFi protocols in full because that is the only way they can release the underlying collateral, which is typically set at 150% of the value of the loan and will be ultimately used to generate a partial recovery for their customers. This shows the ultimate power of DeFi platforms that command the highest priority in the liquidation waterfall derived total payback for their community members! All this was possible as the rules of engagement were programmatically codified, and no individual risk officer could override these risk parameters. This demonstrates the power of DeFi platforms to manage risk and collect dues without ever stepping into a courtroom.
The Crypto Crisis and Similarities to 2008
There are strong similarities between the current Crypto crisis and the global financial crisis of 2008. Just like big bets in the real estate market combined with high leverage unraveled once home prices began correcting in 2008, the current crisis in the broader Crypto market was precipitated by a sudden decline in Crypto prices which became a spark that set the highly leveraged crypto market ablaze. The assets involved were different – real estate in 2008 and crypto in 2022 – but the market conditions marked by excessive risk-taking with massive leverage, poor risk management, and weak business models were very similar. So when real estate and crypto declined in 2008 and 2022, respectively, the entire market unraveled with significant collateral damage to adjacent sectors and market segments. Just like Lehman Brothers became the poster child for the GFC in 2008, Celsius and Voyager have come to epitomize the Crypto crisis of 2022. In 2008, market stress caused some money market funds to break the buck and de-peg, severely hurting investor confidence . This de-pegging caused basis risk, which turned into liquidity risk, and in turn, caused credit risk, eventually resulting in broad contagion, systemic instability, steep declines, and a widespread loss of confidence. Similarly, the dramatic decline in crypto in Spring 2022 caused Stablecoins like Terra Luna to de-peg and pressured Tether and USDC. This reverberated through the entire crypto market, causing counterparty issues, forced liquidations, and market unrest. Luna’s collapse was the spark that lit the whole crypto market ablaze, with Three Arrows Capital receiving the brunt of it all due to high leverage. Just like Lehman bet big on real estate derivatives, 3AC had made highly leveraged bets on crypto using LUNA, which all suddenly collapsed. The 3AC saga is also eerily similar to the hedge fund, Archegos, which created systemic exposure, as the banks weren’t aware of the risk Archegos had accumulated from loans from their prime-broking units.
The irony is that Satoshi Nakamoto’s efforts and the core idea of cryptocurrencies were motivated by a desire to eliminate or largely address the problems of the…
Credit: www.forbes.com /