New Doesn't Necessarily Mean Better: A DeFi Cautionary Tale

Hello defiers and happy Friday! Julien Genestoux of Unlock Protocol is taking over The Defiant today. He writes about the value, but also the potential pitfalls of building a new financial system. The risk is two-fold: Excluding the advantages of the old system, and introducing additional liabilities in the new.

Julien says he’s on a “mission to fix the web” with Unlock, a protocol for content creators to monetize their platforms in a decentralized way. I’m one of the writers using Unlock to offer subscribers the ability to pay with Dai. Click here to pay with DAIthrough Unlock (70 Dai/yr), or click on the “Subscribe Now” button to pay with fiat ($10/mo or $100/yr).

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DeFi is a Feature… of Web3!

By Julien Genestoux

Before 2008, I was a banker. I worked for BNP Paribas, one of the largest banks in the world. When the so called “sub-prime” crisis exploded in our faces, one thing became clear: we’d built a financial system which was not rooted in reality anymore. We’d built a financial system which did not serve the economy… but the interests of a small number of investors and bankers, at the expense of the general public and the economy.

As we build a new financial system, we need to be careful to avoid making the same mistakes. At this point, it’s not clear to me if we are.

Satoshi himself had identified the failings of the legacy system, by famously writing “Chancellor on brink of second bailout for banks” (The Times January 3rd, 2009) in the Bitcoin genesis block. One of the core goals of Bitcoin is to (re)build a financial system which serves the people… one where inflation is not used as a tool to absolve careless investors or collectivize their losses, but to reward the miners who make the system more secure.

Financial infrastructure

Finance is actually an incredibly powerful tool for entrepreneurs, founders and economic actors in general. When a local business has a return on capital invested of 10% and they can borrow from lenders at 5%, they should, as it allows them to grow faster! Lending can be a very powerful leverage which allocates scarce funds to the most efficient businesses.

Similarly, when someone trades internationally, they are exposed to exchange risk as the goods and services they buy now in a currency might be sold only months or years later in a different currency. In that scenario, investors who have exposure to both currencies can “guarantee” an exchange rate by lending, with a margin, either currency to actors on either side. This has the important consequence of reducing risks for businesses who can now operate with a clear understanding of the costs associated with exchange rates.

The promise of decentralization

The “decentralized web” movement (often called web3) has been gaining a lot of momentum in the last few years. People understand better the risks of relying on third party middlemen to host content, organize local transportation or even run applications. These middlemen will eventually act as gatekeepers, not necessarily because they want to, but because they can… and sometimes because they are legally expected to.

However, it is important to recognize that these gatekeepers also provide valuable services to users, including, in many cases, financial services. Uber took over taxis in part because it did not require us to carry cash. Google’s adwords is an incredibly powerful system to acquire customers… etc.

If we are going to obsolete these middlemen, builders of decentralized finance will have to play a major role in making sure users are still receiving those services. Equally important is to make sure replacing middlemen with smart contracts doesn’t turn into a liability!

Can we trust DeFi?

In the last few months, the DeFi ecosystem grew tremendously, but it’s also been accused of “recycling” Ether which was already inside of the ecosystem… The most sarcastic would even say that no “new money” has entered the Ethereum chain and that the DAI supply is only coming from Ethereum whales, while all its flavors cDAI, rDAI, xDAI… are in fact just the same dollars accounted for several times… hiding the real value of the DeFi space.

Similarly, are the savings rate a reflection of demand in the assets, or are they a reflection of the risk associated with the crypto assets themselves? (smart contract bugs or vulnerabilities, legal exposure, …) What would happen if a critical vulnerability was discovered in some of the most used smart contracts in the DeFi space, be it a wallet, a CDP contract or even an exchange? What would the impact be on the decentralized web economy?

Finally, and I know this questions even the “core” foundation of the decentralization movement: how can we recover or help the most fragile users if (or when?) a blackswan event hits the DeFi ecosystem. Four years after the DAO hack, it is clear that the “hardfork” governance is not an option anymore: No one is in charge… but are the risks all gone? What mechanisms has the DeFi space put in place to help build trust and be the fuel it can be on the decentralized web fire?

The value and the risks

Regardless of these questions, so much value is getting built. What many consider the most emblematic DeFi project, Maker, provides stability to the crypto currency ecosystem where volatility has reigned. It is already clear that as much as people love the idea of “hodling” tokens which will appreciate, they generally do not enjoy the idea of paying with them, nor to be paid with them when the value jumps or drops. With its clever over-collateralization approach, Dai guarantees a certain level of stability which, in turn, reduces friction for people purchasing products and services with it. DAI is a UX improvement in service of web3.

Compound, Aave and others can be used by traders to do margin trading, where they can increase their exposure to price changes in order to leverage long or short positions. These smart contracts run 24/7, and their rates and fees are transparent.

Using Unlock, creators like Camila are selling access to their content. In that case, the Lock is itself a “revenue generating asset”. The lock itself can then be “collateralized” by its owner in order to borrow, exchanging future revenues (used to repay the loan) for short term needs. Camila does not have to rely on a “corporation”, she can sell her labor directly to her customers. Similarly she does not need the “approval” of a bank in order to borrow the money she might want to invest in her own work.

GasToken (https://gastoken.io/) has a bad rep as being “wasteful” … but it also provides a very valuable system to hedge against gas price variations which I am sure gas networks which process meta-transactions will want to leverage.

Building a better future

Healthy economies foster peace and prosperity for all. Finance is just a tool toward that goal. Decentralization is a novel methodology which, like many, I believe will prove more efficient, but, in the same way that “exotic” financial products and derivatives are only as valuable as the services they provide to the underlying economy, DeFi is only as valuable as the new decentralized applications and services it enables… and we can only consider the DeFi space to be a success if, indeed, it empowers decentralization, and avoids the pitfalls of the old system.

The Defiant is a daily newsletter focusing on decentralized finance, a new financial system that’s being built on top of open blockchains. The space is evolving at breakneck speed and revolutionizing tech and money. Sign up to learn more and keep up on the latest, most interesting developments. Subscribers get full access at $10/month or $100/year, while free signups get only part of the content.

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About the author: I’m Camila Russo, a financial journalist writing a book on Ethereum with Harper Collins. (Pre-order The Infinite Machine here). I was previously at Bloomberg News in New York, Madrid and Buenos Aires covering markets. I’ve extensively cove