There’s No Future for DeFi Without Regulation

America’s first experiment with DeFi didn’t end well and the second one is going badly, too. Can we learn the lessons of history to make the third try a success?

Believe it or not, the blockchain era is really America’s second experiment with decentralized finance (DeFi). Long before blockchains, the U.S. was the very last of the major industrial countries to establish a central bank. The Federal Reserve System was created in 1913, more than a century after the Bank of England was established and most big European countries had their own central banks as well. Even then, the Fed was established somewhat reluctantly after a series of financial crises.

Prior to the establishment of the Federal Reserve, banking in the U.S. operated like DeFi does today: a kind of “Wild West” with little regulation and no lender of last resort. As a result, a crisis at one bank could quickly lead to contagion at others. The specific crisis that triggered the creation of the Federal Reserve came from a highly leveraged short squeeze that went wrong, leaving the financing company, the Knickerbocker Trust, illiquid. Knickerbocker’s collapse led to a broader stock market plunge and a wave of bank runs.

As in 1913, the idea that regulators had a role to play wasn’t necessarily popular with everyone. The argument then, as it is now, is the same: Bank crises are painful, but they are a form of market discipline, and crypto ecosystems, because they lack central banks, offer a higher standard of discipline and performance.

Crypto was supposed to be better than 19th century banks. The extreme transparency that blockchain technology enables should have made it clear which funds and firms were operating on the edge, exposed to risky products. Four factors came together to make it hard for a transparent, disciplined market to emerge.

Four factors

First, many companies and protocols have started to blend on-chain DeFi with off-chain but still unregulated centralized finance (CeFi). Instead of on-chain components that should be clear and transparent, the trail dead-ends in off-chain assets that are unknown or, worse, pledged to multiple owners. If an asset is pledged as collateral on-chain, that’s entirely visible to others. If the same asset is pledged off-chain, however, a firm might have liabilities far in excess of what people can determine by looking at on-chain data.

Consequently, if the firm doesn’t share that information, assessments made based on-chain data will be dangerously incomplete. Some of this was certainly out-and-out fraud. Much of it was evidence of how badly some firms scaled as they failed to segregate funds or monitor their own processes. It will likely be many months before some of the biggest bankruptcies are fully reported and investigated for us to find out.

Second, transparency has its limits. It’s all well and good that fully decentralized and on-chain systems are readable by end users. That doesn’t mean end users can understand what they are buying or how to evaluate the risks. Only a tiny fraction of crypto buyers have the technical knowledge (nevermind the time) to fully understand the most complex DeFi protocols. In short, as in traditional banking, end users or depositors are dispersed and lack the monitoring expertise to sufficiently discipline these institutions.

Not only are most users not equipped to understand protocols, you cannot have a “flight to quality” without effective benchmarks and other standards for on-chain and off-chain financial services. Banks are subject to liquidity and capital quality standards established by regulators and the results are published.

Finally, markets are not rational in the short run. A speculative frenzy sent everything upwards in the first part of the cycle in early 2021 and despair led people to liquidate quickly in the plunge, which began in November 2021 and continued through much of 2022. Reason may prevail over time, but, in the moment, investors tend not to behave rationally. The automated and interconnected nature of DeFi may accelerate the cascade of panic as well.

It is definitely true that some very well-governed DeFi protocols came through the worst of this crypto winter with little damage, MakerDAO, is a good example. Maker – a DeFi lending system that issues the DAI stablecoin – only briefly de-pegged from the dollar and recovered quickly. The other category of firms that have held up well are CeFi firms that have aggressively courted regulators and auditors with an eye on the long game. The reporting rigor required to get a Big 4 auditor or to go public on a U.S. stock exchange is a powerful incentive for organization

Maturing the DeFi sector matters because it is the future of banking. And banking crises do much more systematic damage to the economy than other industry problems. The purpose of financial systems is (or should be) to channel capital to firms that make investments and drive productivity and growth in the economy. When they stop working, the effects hit across the whole economy. The 1907 banking crisis in the U.S. led to a decline in industrial production of 11% and a drop in imports of 26%. By way of comparison, this is about the same level of decline that occurred in the global financial crisis in 2008.

While the impact of financial crises may not have changed dramatically before and after the creation of the Federal Reserve, the frequency did. In the 19th century, the U.S. had banking crises and panics in 1819, 1837, 1857, 1873, 1884, 1893 and 1896 – and nearly every one of those led to a recession. In the 20th century, however, we had just one major crisis, the Great Depression. So far in the 21st century, we’ve also had one major crisis, the Global Financial Crisis, though its impact was far smaller than the Great Depression, thanks to the vision and insights of then-Fed Chair Ben Bernanke.

For blockchain business ecosystems, the lessons are clear: Without embracing regulatory compliance, government-backed insurance models and fiat currencies built atop professionally run central banks have no viable future. Even the best-run firms will not be able to embrace nearly any level of acceptable risk required to produce a decent return or multiply the value of capital. And without that, there’s no real future for DeFi.

Source: Coindesk

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