Why finance breaks when it goes off-chain
The robustness of the Web3 infrastructure underpinning DeFi has remained incredibly resilient during the turbulence of the past weeks, where we saw the Celsius platform unable to honour customer withdrawal requests and 3 Arrows Capital (3AC) a leading hedge fund collapse due to excessive leverage.
The cryptocurrency markets have depreciated significantly during this period, but the technology underpinning Web3 has remained robust throughout. The leading DeFi projects have all continued to work without any issues, enabling the DeFi markets to function effectively.
The fully-collateralised stable coin USDC has remained pegged to the dollar, lending protocol Aave has continued to facilitate lending and borrowing of digital assets, Uniswap and Curve’s liquidity pools remain intact, and Rocketpool and Lido are providing staking services for Ether.
The robustness of this DeFi plumbing should not be overlooked. As the events, we've seen play out recently are a familiar story in finance. One where greed and leverage by a few individuals or companies disproportionately affect the financial markets. Except for this time around, it is the crypto assets that are suffering.
The irony with all of this is that it’s those services that are centralised which have been able to get away with not disclosing what they are doing, building what on the outside appears to be a new type of institution finding new opportunities for alpha for its customers or investors in Web3, but in reality, they built a house of cards whose brittleness is exposed at the first real turbulence in the markets.
Looking beyond the greedy ambitions of those individuals involved in these flimsy constructions, there are two reasons why they have been able to get away with this.
Firstly, it is the fact that these entities were centralised. Only those on the inside of these organisations could see the true positions that they held. If they had lent to or borrowed from other financial firms, there was no way of ascertaining if they were truly overextending themselves, and pledging the same collateral multiple times or simply lying about their solvency.
Secondly, a lack of regulation for these companies. In the case of Celsius, just like a bank, it was taking customer deposits, but unlike a bank, there was no regulatory framework to which it had to adhere. This meant they could do basically whatever they wanted with customer funds. Be that gambling on a high-risk DeFi project, or locking customer funds in illiquid assets as they did on LIDO.
For all of the criticism that blockchain receives for being fully transparent and therefore not appropriate for your typical financial institution that needs to retain its "special sauce" to ensure it retains its competitive advantage, this transparency provides a level of disclosure that would prevent these collapses from occurring.
A DeFi protocol does not care who is investing in or borrowing from it. All it cares about is that whoever is interacting with it is good for the collateral or fees that it extracts from the transaction. It achieves this by relying on the cryptography and guarantees implicitly provided by the blockchain they are running on.
If someone tries to lend ETH for USDC on Aave, it won't let them do this unless they have the ETH funds available in their wallet to post the collateral which is then locked in Aave for the duration of the loan.
That person can't then go to Uniswap and exchange that same ETH for some other token, as the blockchain does not allow double-spending.
In the world of traditional finance or TradFi, there isn't anything that stops one company from obtaining credit from multiple entities and posting a fraction of the same collateral to each of them. The restrictions on these practices really depend on how joined-up these TradFi entities are. Often the inability to meet commitments only comes out in the wash during times of significant market turbulence as we're seeing right now.
The robustness that comes from the connectedness of pure DeFi applications and protocols as being outlined here is why this is such a transformative technology for finance.
Regardless of how the financial landscape evolves longer term, one cannot imagine a future whereby the interconnectedness of financial platforms underpinned by blockchains do not thrive. The benefits provided by such an approach are simply too great to rely on mechanisms such as voluntary or regulator-mandated disclosure which the financial systems rely on right now which we've seen fail time and time again.
Be that the collapse of Long Term Capital Management in the 1990s, the global financial system in 2008, and now parts of the centralised crypto ecosystem in 2022, history is destined to repeat itself and again and again until we embrace this better approach offered by Web3 technology.
Regulators and governments are already aware of the opportunity provided by Web3 with it being embraced in areas such as central bank digital currencies and in the wholesale payment markets.
Whilst there continue to be some uncertainty as to what approach becomes the default down the line, and what this looks like from an end-users perspective, we know that as soon as things move off-chain — no longer traceable on a blockchain, the opportunity for problems caused by greed or poor risk management start to resurface again.
Humans are infallible, machines are less so, and blockchain technology enables the financial industry to simplify risk management for organisations in a manner that simply isn't possible with previous generations of technologies, since they reside on private networks, within the boundaries of a single organisation.
I've written previously about how DAOs will change the manner in which companies can be run, providing significant upside for tax authorities, and I'm confident that with time we'll see Web3 technology embraced, even mandated for regulators due to its ability to make their lives simpler.
Whilst the robustness of DeFi has been proven with this latest failure in CeFi, it’s not yet a panacea — there are still usability issues we need to see addressed, and it hasn't been immune from scams and hacks (much like TradFi), but given how early we still are in the evolution of Web3, it’s only a matter of time before these issues are solved.
Hopefully, then we can find a way to eliminate a lot of the centralised, off-chain financial structures that exist in the world in favour of something that remains on-chain, with all the resiliency, security and transparency benefits we get from Web3 technology benefitting the financial landscape.
Such a change is something to get really excited about, as it will ultimately benefit the end-users of financial services, who are those that need to be protected most of all, as they are the ones who suffer most from the events such as those that have played out in the past couple of months.