Decentralized Finance: Efficiency vs Risk

Decentralized Finance: Efficiency vs Risk

According to a recent IMF report, Decentralised Finance (DeFi) is currently more cost-efficient but riskier than Traditional Finance (TradFi). In this article, we discuss the sources of efficiency and the risk factors for DeFi.

Introduction

Decentralised Finance (DeFi) has the potential to replicate most if not all the functions of Traditional Finance (TradFi) in a more cost-effective way. The efficiencies are mainly driven by the removal of any intermediaries, by enabling better automation, and by lowering the barriers to entry, hence increasing competition. According to a recent IMF report, DeFi platforms have the lowest marginal cost and the lowest margins between borrowing and lending rates when compared to banks, as shown in Figure 1. However, DeFi is also much riskier, mainly due to the overabundance of leverage and cyber-attacks, as well as various governance and liquidity risks. In this article, we discuss the sources of efficiency and the risk factors for DeFi.

Figure 1

                                                         

Source: “Global Financial Stability Report”, April 2022, IMF.1

Sources of Efficiency

No Intermediaries

The main source of efficiency comes from the ability of distributed ledgers to record the ownership and the transfer of cryptoassets, without the need for intermediaries that complicate the process and add costs. Furthermore, smart contracts enable the automation of key financial services such as depositing, borrowing and lending, derivative trading and exchanges, thus reducing the labour costs which are a significant part of operation costs. Smart contracts are computer programs that reside on distributed ledgers and execute when certain conditions are met. By removing the need for any intermediaries, these financial services can in principle be executed in a more transparent and predictable way. 

Regulation

Transparency can make regulation and compliance more cost effective as well. If a financial product is just a smart contract, the regulator can easily check it by inspecting the computer code. The contracts are likely to become standardised over time as a small number of contracts become battle tested in the real world (minimising the risk of code bugs). Moreover, as all transactions are recorded on distributed ledgers, they can be monitored in real time. Although there is very little regulation in DeFi now and this contributes to its lower marginal cost, this will change soon.

Composability

Another source of efficiency comes from the inherent composability of DeFi, which can generate highly competitive markets that decrease prices, lead to better products and greater consumer choice. Composability refers to the ability of any market participant, who has self-custody of their cryptoassets, to build their own custom bundle of services, using different protocols for trading, depositing, borrowing, and lending. This is very different from TradFi, where asset custody is with a bank, which then sells their own bundle of services to their depositors. As a customer is unlikely to switch banks over small differences in prices, each bank has some monopoly power over their clients, which then allows them to increase prices. Moreover, they can use the proprietary information they have about each costumer and their past transactions to price discriminate. On the supply side, a new DeFi service or product can “plug-in” with most existing protocols and it is accessible to all market participants without many frictions other than technical knowhow, which decreases as this software develops further and becomes more user friendly. This lowers the barriers to entry and increases competition. In TradFi, the intermediaries that provide custody for assets act as gatekeepers and have the incentive to increase the barriers to entry for newcomers, therefore acting in favour of the incumbents.

Risk Factors

Any new and emerging asset class is bound to be very risky, as the valuations are based mostly on the future potential rather than the past performance. However, in DeFi there are some unique sources of risk that are worth exploring.

Low Margins

The low margins in DeFi are due to the intense competition and the absence of regulatory requirements for buffers. Although they are a source of efficiency, they can also be a risk factor if they result in under-pricing risk and eventually the failure of lenders during extreme market conditions, as we saw recently.3 Moreover, the low margins may deter TradFi institutions from entering DeFi, as they enjoy much higher margins in their existing markets. Their absence allows smaller players to dominate the space, however they often prove inadequate when market conditions become unfavourable. 

Liquidity

Liquidity can enter and exit a distributed ledger very fast, as the depositors are always looking for the highest yield and the transfer of value between ledgers and protocols has become very easy. These liquidity risks can result in the failure of protocols and ledgers even if their fundamentals are good. In general, every ledger operates as a small open economy, which means that the failure of one part could lead to the failure of the whole ecosystem. One such example is the Terra blockchain. The failure of its stablecoin, UST, was so significant, that it led to the collapse of the whole ledger and all the native protocols.

Governance

DeFi protocols are sometimes organised around a Decentralized Autonomous Organization (DAO), which is a relatively new and untested form of governance. Although DAOs have many merits, it remains to be seen whether they are the most effective way of governing protocols.2 Especially in times of market turmoil or a long bear market, the anonymity and the lack of accountability in DAOs, as there is no CEO or board of directors, could lead to the abandonment of a protocol. Decentralisation also leads to a less efficient decision making process, which is why many projects start off centralised, when coordination is most important as the core protocol is still being built, and then become decentralised over time as the protocol becomes established.

Leverage

DeFi involves a significant number of leveraged trades, which use cryptoassets as collateral. More than 90% of lending is in stablecoins, while around 75% of the collateral is in volatile crypto assets (Figure 2, panel 4). In good times, this can create a virtuous cycle of increasing prices, increased speculative demand and a decrease of the supply of tokens, as many stake them to receive rewards from ledgers and protocols that try to gain market share. In bad times, however, this virtuous cycle reverses and the decrease in prices can be even more violent. This is aided by two factors. 

• First, as the collateral for a leveraged trade is another cryptoasset, a downward movement in the market makes collaterals less valuable and leads to liquidations, which are then executed by immediately selling the collateral, further depressing prices (see Figure 2, panels 3 and 4, on how borrowing and liquidation work). The trustless nature of distributed ledgers means that a loan is usually overcollateralized, so when it is liquidated the decrease in price is significant.
• Second, the transparent nature of distributed ledgers means that the liquidation price and the amount of the collateral are usually public knowledge. This can incentivise market participants to short sell the cryptoasset once its price is dangerously close to the liquidation price, so that they can liquidate the loan, claim, and sell the collateral. In other words, the fact that leveraged loans are public knowledge can create a self-fulfilling equilibrium where each liquidator, fearing that someone else might act quicker, forces the prices of the traded and the collateral assets to drop.

Figure 2

Source: “Global Financial Stability Report”, April 2022, IMF.1

Cyber-attacks

Finally, there is an increased risk of cyber-attacks due to smart contract failures, compromised wallet keys and scams by developers, as shown in Figure 3. A cyber-attack can create a “run on the bank” effect, as depositors withdraw their assets from the protocol to avoid any further losses. If the attack is significant, it can create a knock-on effect and the liquidity dries up for other protocols in the same chain.

Figure 3

                                               

Source: “Global Financial Stability Report”, April 2022, IMF.1

Conclusion

DeFi has lower marginal cost and lower margins as compared to TradFi, due to higher competition, fewer intermediaries, and less regulation. However, it is also riskier, due to liquidity and governance risks, cyber-attacks and overabundance of leverage. As the infrastructure and market evolves, the efficiencies should outweigh the risks as DeFi becomes more prominent in the market for financial services.

Footnotes

1 The report can be accessed at https://www.imf.org/en/Publications/GFSR/Issues/2022/04/19/global-financial-stability-report-april-2022.
2 For more details, see the report “Decentralization and Economic” at https://en.aaro.capital/Article?ID=3098d61c-fc73-4413-b9f9-6232b2a7a47d.
3 Note, however, that the recent market issues were caused by centralised parties taking on too much risk.

Disclaimer

Aaro Capital is the trading name of Aaro Capital Limited (“Aaro”), a private limited company, registered in England and Wales with number 11419585, whose registered office is at 5th Floor 14-16 Dowgate Hill, London, United Kingdom, EC4R 2SU. Aaro is not authorised or regulated by the Malta Financial Services Authority ("MFSA") or any other financial regulator.

The material provided in this article is being provided for general informational purposes. Aaro does not provide, and does not hold itself out as providing, investment advice and the information provided in this article should not be relied upon or form the basis of any investment decision nor for the potential suitability of any particular investment. The figures shown in this article refer to the past or are provided as examples only. Past performance is not reliable indicator of future results.

This article may contain information about cryptoassets. Cryptoassets are at a developmental stage and anyone thinking about investing into these types of assets should be cautious and take appropriate advice in relation to the risks associated with these assets including (without limitation) volatility, total capital loss, and lack of regulation over certain market participants. While the directors of Aaro have used their reasonable endeavours to ensure the accuracy of the information contained in this article, neither Aaro Capital Limited nor its directors give any warranty or guarantee as to the accuracy and completeness of such information.

Please be sure to consult your own appropriately qualified financial advisor when making decisions regarding your own investments.

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