On the Sustainability of Decentralized Finance

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:On the Sustainability of Decentralized Finance | by Terry | Coinmonks | Jul, 2021 | Medium

Declining Sovereign Credibility

According to the Edelman Trust Barometer 2021, trust in government worldwide is declining[5], 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[8]. 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.”[9] 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 Challenges

For 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:

• Volatility is too high.
• It is difficult to short.
• There is hardly any fixed income product.
• 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.