The Inadequate DeFi Lending Regime
The current DeFi lending regime is a leveraged play of highly correlated assets, which is severely inadequate and inherently risky. Credit-based DeFi is urgently needed.
The DeFi lending protocol, up to the penning of this paper, has been primarily an cryptocurrency-backed financing regime with over-collateralization (OC) as its main methodology. Taken at face value, this methodology would restrict monetary growth with the upper limit set at the immediately available tradable cryptocurrencies on the local blockchains, multiplied by the Loan to Value ratio.
But this upper limit is practically useless. The open and permissionless nature of DeFi protocols allow, or even encourage, asset owners to pledge on one protocol and use the proceeds to buy more collaterals to pledge again, and keep repeating the process. Therefore, the entire crypto lending regime is essentially a leveraged play of cryptocurrencies to any arbitrary level.
What makes matters worse is that these collaterals are so highly correlated to the degree that they can virtually be thought of as one, with the only difference being their trading liquidities. Cross-chain technology, even at its best, can only pool very similar assets into one place. It does little to "cross" any assets that are heterogeneous to each other to diversify the risk of uncontrollable leverage. The flood of “utility tokens” that fuels the collateral-based DeFi leveraging has already caused huge damage to investors and harmed the reputation and validity of the industry.
If the DeFi movement is to gain wider legitimacy, financial products that are structurally different and ecologically diverse must be introduced to blockchains. A large class of instruments in this category is credit-based, bespoke, and non-fungible (in nature) financial products that are assured by transparent and verifiable processes, from ecosystems that generate tangible values. Selling “shitcoins” as “utilities” to finance on-chain business is a dying game.
There is an urgent mandate of financially focused DAOs that are rigorously constructed, flexibly operated, and professionally equipped to create credit performance on blockchains, thereby creating credit-based financing.
Yet the hastily designed DAOs of the past cannot get close to fulfilling the aforementioned mandate and meeting the challenges. Fraught with plutocratic governance schemes, Sybil-infested incentive structures, and opaque financial management, the failures have threatened the legitimacy and applicability of DAO as a valuable augment to the traditional corporate structure. Such integrity issues aside, the lack of effective and professional financial tooling further limits the potential of DAOs, making them fractured and insignificant entities only able to do business with limited scope.
There are indeed many DAO tools in the market aimed at meeting this sector’s mandates and their derived requirements. In practice, however, tasks carried by most DAOs cannot be solved by one integrated platform that includes all the necessary functional components. Decentralized organizations with non-trivial business goals, similar to a real-world organization, are left to find ways by themselves to assemble a collection of dApps and make them work together. The result is awkward, inefficient, and often ineffective management structures.
Although many such dApps do have certain ability to be integrated with, there is the crucial issue of procedural flow, often exploitable due to lack of on-chain execution. For example, the high-level decision-making process involving financial activities and the actual execution of these activities are very difficult to separate, particularly if the connection between them must be implemented on-chain to assure integrity and transparency. "Gluing" multiple dApps together doesn’t produce the desired effectiveness, and it’s a frustrating and exploitable process.
Last but not least, is the paradox that has long been plaguing the crypto industry: centralized entities have been dominating the assets originating from decentralized networks. While this had wreaked repeated havoc since the birth of crypto CeFi facilities, it had finally culminated in the spectacular collapses of multiple centralized giants in 2022, including 3AC and FTX. In light of such catastrophes, no one should have any illusion of avoiding regulation of crypto financial activities.
While DeFi seems to be the obvious answer to transparency, one must be very conscious about one fact: pure transactional DeFi protocols do not make up a compliant management structure - they are the necessary components of such a structure. From an operational viewpoint, they are the facilities at the downstream of the decision making & execution workflow. Without enforceable rules of how to use them, no one can mitigate the financial risks even when they work with open source DeFi facilities, and it is certainly not going to pass the regulatory muster. Making on-chain financial governance transparent, accountable, professional, and compliant has never been more critical.