Today, I read a very interesting and insightful article. Terry, the author of the article, believes that DeFi is a solution to resist inflation and sovereign risk, but it still faces some structural challenges, which is worthy of our further exploration.
Here is the original link：
https://medium.com/coinmonks/on-the-sustainability-of-decentralized-finance-d9aa82dd2fcbIn order to make it easier for you to read, I pasted the article here again.
Bitcoin has plunged alarmingly close to $30,000, losing roughly 50% of its peak value in mid-April. When (or whether) it shall rise to its former heights is for brave souls to surmise, but for all its misfortunes in the recent months none has ventured to denounce it a fraud, or to deride the edifice of decentralized finance a mere scam. The mood, it seems, has shifted.
Decentralized Finance (DeFi) is now a $100 billion sector, and by some measures crypto derivatives volumes in June totaled $3.2 trillion, and by all measures DeFi has grown too large to dismiss. Howard Marks, the venerable credit investor who espoused the principles of value investing, has famously changed his mind on Bitcoin. He is by no means alone in the pantheon of investment legends. Soros Fund Management, Paul Tudor Jones, Carl Icahn, Ray Dalio … All have expressed interest in DeFi, or admitted outright the ownership of crypto assets. Big capital is starting to pay attention.
Before one utters the four most dangerous words in financial history — this time is different — it is prudent to reflect on the forces behind this shift, and to examine the conditions for the shift to sustain. Despite its impressive growth, decentralized finance, for the most part, is not supported by decentralized economies, which remain sporadic and nascent across various blockchains. Almost all of the world’s economic activities still take place off blockchain, and mediated by traditional capital, which must continue to shift towards DeFi for it to outlast the incestuous speculative frenzy.
Declining Sovereign CredibilityAccording to the Edelman Trust Barometer 2021, trust in government worldwide is declining, where governments in UK, US, Japan and France sit squarely in the “distrusted” category along with Mexico and Russia[6]. Even mighty China, whose citizens generally credit the government’s competence in handling the COVID-19 pandemic, is no exception[7]. Business is now more trusted and CEOs are expected to lead on long term social issues where government has fallen short. As the wealth gap widens, and political demagoguery grips liberal democracies, and social media emboldens psychological echo chambers, this trend may yet last.
Competence in dealing with a health crisis aside, the economic consequences of government response has agitated long term holders of capital. Lawrence Summers, former Secretary of Treasury of the United States, has observed that President Biden’s stimulus bill is much larger than President Obama’s response to the Great Recession of 2009. In fact, “relative to the size of the gap being addressed, it is six times as large.”Add to that the perennial political gridlock on budget debates in the US Congress, and the trillions of US national debt, and the seething feud between United States and China, and the fact that fiat money rests on the trust of sovereign governments to behave responsibly with the money printing press, long term holders of capital have good reasons to feel agitated.
But if all the world that you know is Roman, for the whole world was once practically Roman, far into strange lands you must venture to hedge the demise of Rome, however remote that might seem.
Structural ChallengesFor those looking to diversify long term asset allocation and to hedge the cracks in the contours of geopolitics, the far and strange world of DeFi offers potential beyond the lure of high returns. The reasons are many, but that it is truly strange and different warrants more merit than it seems. In the world of globalized markets, where the correlation of nearly all asset classes collapses to one in extreme events, the one truly strange and different asset may save the day.
That said, DeFi must overcome a few structural challenges to continue to draw traditional capital:
1.Volatility is too high.
2.It is difficult to short.
3.There is hardly any fixed income product.
4.There is no lender of last resort.
There are more than 2,000 cryptocurrencies in the world of DeFi, and most are far more volatile than Bitcoin. Some could show 1000% vega (i.e. the change of value in a financial derivative relative to 1% of its implied volatility). Trading takes place 24/7, with rules governed by code. In other words, DeFi is always marked to market, with no closing period and little human mediation in actual trading. Arbitrageurs seeking to exploit mispricing, inefficiencies and information asymmetry could not ask for a more perfect market environment, so do gamblers who seek thrills and winnings in a game of chance. More traditional institutional investors, however, cannot tolerate the volatility of one asset that puts the portfolio net asset value into a manic-depressive ride, despite all the diversification benefits. While an open safari for courageous traders, DeFi still frightens long term holders of capital seeking to preserve wealth.
Closely related to volatility is the difficulty to short. When an asset trades at 1000% volatility, borrowing to short it is an easy path to poverty. The solution is financial derivatives, where one can create a risk profile to trade volatility, tone it down to desirable levels in exchange of giving up the opportunity of large gains, and express a short position in the form of optionality.
And DeFi has been offering derivatives, in fact, in the trillions. However, it will take time for the DeFi world to absorb decades of derivatives lessons from traditional financial markets. While not necessarily financial weapons of mass destruction, derivatives can be treacherous, and the management of derivatives trading even more so. Unlike stocks, the underlying crypto assets do not conform to standardized legal templates governed by jurisdictions. Standardized options and futures alone will not suffice.
In traditional financial markets, credit derivatives offer insights. Credit assets, in the form of loans and bonds, differ in term structure, rating, seniority, and come with many other features idiosyncratic to the issuer. Thus credit derivatives, to accommodate these features, are often bespoke. One can trade them, but not on centralized exchanges.
DeFi derivatives must also fulfill the need for fixed income for traditional capital, which often seeks wealth preservation. One can debate whether crypto assets are truly currencies, but that they do not pay coupons is of no debate. Without sovereign jurisdictions to define senior loans or bonds along a capital structure, derivatives, mainly in the form of swaps, will emerge as an important channel to create fixed income products, or what would closely resemble them. One could always lend crypto assets at an interest rate, but without central banking the genesis of leverage will not be so simple. Swapping total returns on crypto assets in a defined range could serve as a good proxy for fixed income type returns.
And last but the not least, the smooth clearing of derivatives, especially in stressful markets, requires some sort of lender of last resort, which strikes at the heart of DeFi.
In traditional financial markets, central banks assume that role by default. In the last financial crisis, central banks acted in concert with finance ministries around the world to rescue the markets, fulfilling simultaneously the roles of lender of last resort for banks and buyer of last resort of securities, especially toxic ones. With no sovereign power, no national borders and no printing press, how the DeFi world would create that role or supply a surrogate will remain its central challenge. Suffice it to say that, nationalized central banks, the BIS and the IMF have not come to pass by the forces of nature. In ages past, various institutions have acted as the lender of last resort, and buyer of last resort, and not necessarily backed by sovereign states.
Closing ThoughtsAs 2021 enters into the second half, a weary world prepares a long farewell to the COVID-19 pandemic, and capital owners remain wary of its economic consequences, especially for monetary and fiscal policies. This is a propitious time for DeFi, as the faith in governments to handle those policies is shaken.
The challenges to DeFi are many, and not limited to the ones listed above. Whereas operational issues such as custodianship and margin lending can be resolved with technical advances and institutional arrangements, the structural challenges aforementioned will press for ingenuity from the DeFi world. If these challenges are adequately met, bridges shall extend from traditional finance into DeFi, and the far and strange places may yet redraw the contours of the world once again, as they once did for Rome.
