Why “Decentralized Finance” Contains Huge Financial Risks

Recently, the Bank for International Settlements (BIS) released a report calling decentralized finance (DeFi) “decentralized illusion” and warned of the risks that the rapid development of DeFi may bring.

DeFi provides financial services such as trading, lending and investing on the blockchain by using cryptocurrencies and smart contracts. Its most prominent feature is that it does not rely on any existing financial intermediaries. In other words, DeFi provides traditional financial services similar to financial services, while achieving financial disintermediation.

DeFi has developed rapidly since 2020, but it contains huge financial risks and deserves vigilance. On the one hand, the DeFi market is characterized by high leverage and pro-cyclicality, and lacks a buffer mechanism to deal with external shocks. On the other hand , the various stablecoins widely used in DeFi are actually not “stable”, and there are liquidity mismatches and operational risks. At the same time, DeFi has high anonymity and is easily exploited by criminal organizations.

On the whole, the current DeFi is basically independent of the traditional financial system. If the connection with the traditional financial system is further strengthened in the future, its potential risks will have a greater impact on financial stability, and it must be highly concerned and supervised in a timely manner.

*This article is part of the CF40 Results Briefing Series

Definition and Operation Mode of DeFi

What is DeFi?

DeFi, namely Decentralised Finance (Decentralised Finance), is the product of the combination of cryptocurrencies represented by Bitcoin and Ethereum, blockchain and smart contracts.

First of all, DeFi is a model of the encrypted financial system. According to whether crypto assets are involved, we can distinguish the financial system into the traditional financial system (which does not involve crypto assets) and the encrypted financial system. Among them, according to whether to rely on centralized financial institutions or trading venues , we can divide the encrypted financial system into DeFi (not relying on) and CeFi (centralized finance) (see the attached table for details).

Second, the core of DeFi lies in “decentralization”. DeFi provides financial services such as trading, lending and investing on the blockchain through the use of cryptocurrencies and smart contracts, but does not rely on any centralized financial institutions, intermediaries or trading venues. In other words, DeFi provides financial services similar to traditional financial services, while achieving financial disintermediation.

Third, DeFi also has a fairly high level of anonymity. Both parties using DeFi transactions (lending) can directly conclude transactions, all contract and transaction details are recorded on the blockchain (on-chain), and this information is difficult to detect or discover by third parties.

Schedule: Crypto Financial System vs Traditional Financial System

Why "Decentralized Finance" Contains Huge Financial Risks

How does DeFi work?

DeFi has two pillars, one is the stable currency represented by Bitcoin and Ethereum, and the other is the smart contract that realizes trading, lending and investment.

First, stablecoins are the primary medium for transferring funds between DeFi users. Stablecoins are cryptocurrencies designed to anchor the value of fiat currencies such as the US dollar. They play a very important role in DeFi, playing a key role in facilitating the transfer of funds across platforms and between users, as well as connecting the crypto financial system and traditional financial system.

Second, smart contracts play a key role in replacing centralized financial intermediaries and exchanges such as banks in providing financial services for trading, lending and investing.

For example, in transactions, counterparties are often matched through smart contracts – Automated Market Makers. In lending, usually to protect the lender, smart contracts automatically liquidate when the collateralization ratio of the borrower’s account falls below a certain threshold (usually 100%). For example, someone borrows 5 BTC with 1 BTC as collateral in DeFi, but when the asset value in the person’s account is less than 5 BTC (such as 4.5 BTC), the smart contract will Collateral is forfeited and liquidated automatically. 

DeFi has shown rapid development since 2020

Since 2020, DeFi has grown rapidly in terms of stablecoins, loan size and investment:

First, the scale of stablecoins has grown exponentially. The size of stablecoins has grown exponentially since mid-2020, with the market value of major stablecoins at about $120 billion by the end of 2021, while the largest money market fund is about $200 billion.

Second, loans to DeFi platforms have increased rapidly. DeFi loans tend to be over-collateralized, reaching $20 billion by the end of 2021, due to high levels of anonymity and volatility in the price of cryptocurrencies used as collateral. In addition, some platforms also offer unsecured loans, with the largest Defi platforms disbursing about $5.5 billion in such loans from mid-2020 to the end of 2021.

The third is the gradual rise of DeFi portfolios. The development of DeFi lending platforms has also encouraged the development of applications similar to investment funds in the traditional financial sector. DeFi portfolios follow a pre-determined investment strategy, pooling investors’ funds and automatically transferring them to crypto lending platforms for profit. By the end of 2021, the two main decentralized portfolios will be around $10 billion.

DeFi still has certain centralized characteristics

There is a risk of “collusion”

DeFi tends to give the illusion of complete decentralization, but the opposite is true. Because algorithms cannot predict all possible situations, this leads to the inevitable existence of a certain degree of centralization in the DeFi system.

First, all DeFi platforms have a centralized governance framework. The main body of governance is usually platform developers, and the content of governance includes how to set strategic and operational priorities. The method of governance is usually to vote on proposals based on the number of holdings of a special currency, which is similar to a stake. Obviously, this is similar to shareholder participation in corporate governance.

Second, under certain institutional arrangements, decision-making power may be concentrated in the hands of those large stablecoin holders. For example, some blockchains will reward them according to the number of stablecoins held, and the higher the number of holdings, the higher the reward. Additionally, many blockchains allocate a significant portion of the initial stablecoin to insiders, exacerbating the problem of centralization.

Finally, the centralized arrangement that actually exists leads to the “collusion” of a small number of accounts with potentially large holdings.

  • One is that these few accounts with large holdings may join forces to gain financial gain by altering the blockchain.
  • The second is the possibility of significantly increasing the fees paid to them by other traders by making fake transactions between their own accounts.
  • The third is possible specific trading strategies to obtain higher profits, such as “front-running”. However, “front-running” is punished by regulatory authorities in the traditional financial system, but lacks corresponding regulatory measures in DeFi.

DeFi has obvious vulnerabilities

DeFi is still in its infancy, providing financial services similar to the traditional financial system, and naturally has similar vulnerabilities. However, features such as the high leverage of DeFi make it even more volatile.

First, the DeFi market is characterized by high leverage and pro-cyclicality, and lacks a mechanism to deal with external shocks.

First, the high leverage ratio of DeFi mainly stems from two aspects. On the one hand, there is the phenomenon of double collateralization, that is , the funds borrowed in one transaction can be reused as collateral for other transactions, which directly increases the leverage ratio . On the other hand, derivatives trading leverage in decentralized markets is higher than existing exchanges that can be regulated.

Second, the high leverage of the crypto market exacerbates the pro-cyclicality, that is, under the premise of high leverage, the price increase will lead to greater collateral value and trading profits, which will further drive the price increase.

Third, DeFi relies entirely on private guarantees (collaterals) and is isolated from traditional financial markets and regulatory authorities, so it lacks the necessary buffer mechanisms in the face of external shocks.

For example, in September 2021, the price of crypto assets experienced a rapid decline, which resulted in forced liquidation of derivative positions and loans on DeFi platforms, which further exacerbated the sharp decline in crypto asset prices and the surge in volatility, forming a vicious circle.

Second, the so-called “stable currency” is not actually “stable”, and there are liquidity mismatches and operational risks.

First, stablecoin vulnerability performance depends on its design mechanism. For example, for stablecoins backed by secondary market securities such as commercial paper, the collateral assets are illiquid and have liquidity mismatch risks ; for stablecoins backed by collateral such as cryptocurrencies, the value of collateral assets may be lower than the face value of the stablecoins and have market risk . Although these risks can be offset as much as possible by over-collateralization, they are also difficult to cover when market volatility is too high.

Second, liquidity mismatches and market risk increase the likelihood of investor selling. The success of stablecoins depends on the level of trust investors have in the value of the underlying asset, and a lack of transparency and regulation can easily erode that trust. When investors have doubts about the quality of an asset, they have an incentive to sell stablecoins first in exchange for fiat currencies (such as USD). Such selling could trigger a run, causing collateral to be sold cheaply.

Third, although the current DeFi is basically independent of the traditional financial system, the correlation may gradually increase in the future, and the spillover impact of DeFi on the traditional financial system may become more and more significant.

For banks, more conservative regulation limits their participation in the cryptocurrency ecosystem . Asset-wise, bank loans and equity investments have limited exposure, with large banks’ equity investments in crypto-related companies ranging from $150 million to $380 million by the end of 2021, a small fraction of their capital. On the liability side, some banks are able to obtain funding from DeFi, and stablecoins may hold bank deposits or commercial paper. Therefore, a run on stablecoins may have a certain capital shock to banks, similar to the impact of a run on money market funds.

For non-bank financial institutions, mainly family offices and hedge funds, there is growing interest in DeFi and the wider cryptocurrency market . Their purchases of crypto assets have grown from about $5 billion in 2018 to about $50 billion in 2021.

policy suggestion

DeFi is still in its early stages of development, but with improved blockchain scalability and large-scale tokenization of traditional assets, DeFi may play an important role in the financial system in the future. Given that the main challenges DeFi currently faces are similar to those of the traditional financial system, existing rules can be referred to for its regulation.

First, the regulation of DeFi activities should follow the principle of “same risks, same rules”. Regulatory measures should allow DeFi participants to internalize the costs of a highly leveraged pro-cyclicality. In order to prevent the risk and widespread spread of stablecoins, the regulatory authorities can learn from the relevant rules of current banking supervision, measures to strengthen the prudential supervision of investment funds in securities supervision, and international risk management standards for payment infrastructure. Agencies responsible for regulating market integrity and illicit financial activities should also bring DeFi activities under their supervision.

Second, the fact that DeFi is not completely decentralized can be a natural entry point for supervision. DeFi platforms exist as a group of stakeholders who are responsible for making and implementing decisions, exercising governance or ownership functions. These stakeholders, and the governance protocols they rely on, are natural entry points for regulation, enabling regulators to bring DeFi-related issues into regulatory scope and effectively control risks before the DeFi ecosystem becomes systemically important. Bringing it into regulation early will also help ensure that DeFi innovations benefit the financial system as a whole.

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/why-decentralized-finance-contains-huge-financial-risks/
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.

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