Secular financial system is better than reckless new DeFi

In the history of dangerous naivety, the decentralized finance mania of 2021 will hold its own in the face of the 2007 collateralized debt boom. It took a financial crisis for the world to understand CDOs, which repackaged risky mortgage bonds to make them safer than they were. “CDOs are nothing but a massive Ponzi scheme,” said the villain of a fictional account of the 2008 collapse. based on the blockchain are equally reckless?

The idea that one could ditch regulated intermediaries like banks and earn much higher returns by lending digital assets was a key attraction of decentralized finance, or DeFi. But that was before the bloodshed began, sparked by the collapse last month of the Terra-Luna cryptocurrency pair. The allure of changing money into TerraUSD, a stablecoin that promised 1:1 convertibility to dollars, was the almost 20% return on TerraUSD deposits. The withdrawal of funds from Anchor Protocol, the leading DeFi lending app on the blockchain, crashed the coin, along with Luna, its sister asset.

Soon after, lenders Celsius Network and Babel froze deposits. BlockFi Inc., a lending platform backed by Peter Thiel, said it had “fully liquidated or covered all associated collateral” from a large client believed to be Singapore-based Three Arrows Capital, a struggling crypto hedge fund. BlockFi is cutting its workforce by 20% as Coinbase Global Inc., the largest US-based digital asset exchange, lays off 18% of its workforce. There is no end in sight to the crypto winter. Of the $252 billion in investor funds tied to DeFi protocols 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. “Assessing borrower risk using proven methods – from bank selection to confidence in the reputation of informal networks – is therefore not possible,” researchers at the Bank for International Settlements recently noted. Thus, the loans must be over-collateralized in order to compensate for the missing confidence. But as recent events have shown, Bitcoin loans with Ethereum collateral can be just as combustible as the portfolio of subprime mortgage bonds backing a CDO.

Compare the fragility of Defi with the robustness of ‘hawala’, a highly efficient money transfer system in the Middle East and the Indian subcontinent since medieval times. If DeFi relies on software code to substitute for courts in enforcing contracts, hawala seeks to fill the legal void with confidence. As Matthias Schramm and Markus Taube described the institutional arrangement in their 2003 article:

“(Hawala) is able to move large sums of money without resorting to the formal banking system and even without keeping accounting records. Instead, it is based on the trust of the participating parties and its social and religious anchorage within the Islamic community”.

Modern regulators hate hawala because users of the club-like multinational network can easily circumvent anti-money laundering and terrorist financing laws. Yet, given the way the system works, it is almost impossible to erase it, or even to detect it. Hawala intermediaries often maintain regular banking relationships that are indistinguishable from legitimate small business accounts.

Good or bad, hawala is a very real money transfer product – and has been for centuries. In contrast, much of DeFi is just a kabuki of decentralization. The Crypto brothers talk a lot about defying the tyranny of government controls and large custodian organizations, though in reality DeFi cannot even match the success, in this regard, of a pre-modern alternative. Hawala was born to circumvent the anarchy that plagued medieval traders traveling long distances; she then learned to live outside — but alongside — the law.

That’s not all. To be a DeFi borrower, you need more crypto collateral than the loan you are looking for. This restricts “access to credit to borrowers who are already asset-rich,” the BIS report notes. For DeFi lending to become a serious financial inclusion tool, two things need to happen. First, people must be able to take out loans under their real name to establish a trustworthy pattern of behavior. Second, more real-world assets like buildings and equipment need to get digital representations on the blockchain so that even the less wealthy have some upfront collateral.

Despite all the concerns about big tech platforms taking advantage of consumer data, fintech does much better than DeFi when it comes to inclusion. The machine-learning-based scoring model of online trading platform MercadoLibre Inc. is demonstrably superior to what credit bureaus can tell a conventional bank about the creditworthiness of borrowers in Argentina. Ditto for the Alipay payment network of Ant Group Co. in China. The fintech has added a wider range of information – about a broader set of potential borrowers – than traditional lenders could uncover about a select group of people within existing banking relationships. This had a big impact on emerging markets. A jar of Nutella sold by a family store in India is now telling a potential lender something valuable about its owner’s creditworthiness.

Ignoring borrower-level information – or losing it in the labyrinths of financial engineering – does not end well. Think of highly rated senior CDO tranches where the underlying mortgages were subprime. DeFi must abandon its techno-anarchist utopia and become more real and centralized. Otherwise, DeFi lending will go down in the annals of finance as a failure where hawala was a success: a trustless 21st century technology losing out to a 14th century innovation that thrived on maintaining supreme trust.

(This story has not been edited by NDTV staff and is auto-generated from a syndicated feed.)

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Don F. Davis