How to Avoid the Death of DeFi in the Wake of FTX

The crypto exchange’s collapse is an inevitable outcome for an industry yet to find its use case. For crypto to survive, it needs to learn from the very financial sector it set out to replace, says Brent Xu, the CEO of Umee.

AccessTimeIconFeb 9, 2023 at 9:24 p.m. UTC

Decentralized finance (or DeFi) is characterized by speed, autonomy and transparency unmatched by legacy banking institutions. The financial crises of the past half-century, brought about by opacity, obfuscation, inefficiency and excessive human meddling, clearly justify these innovations.

Yet, as evident by numerous crypto scandals in the last year – most notably the collapse of the FTX crypto exchange – the industry hasn’t been able to lean into DeFi’s inherent advantages. While decentralized trustless technology is revolutionary, we watched as the industry was being run by centralized organizations like FTX, which are far more susceptible to fraud at the hands of corrupt leadership.

Brent Xu is the CEO and co-founder of Umee.

The uncomfortable truth is that to build lasting value, DeFi and blockchain need real-world use cases. Without a value proposition beyond “line-go-up,” it's difficult to justify DeFi’s innovations. Blockchain just becomes an overly complex mechanism for classic casino capitalism. It’s no wonder profit-minded investors ignore the nerdy tech and instead flock to the slickest snake oil salesman.

Ultimately, the way to end fraud and criminality in the crypto space is to give DeFi a clear and justifiable use case. To this end, the industry needs to take some cues from the traditional banking sector.

Why does traditional finance work?

Traditional finance gets a fair amount of criticism – and rightfully so. The greed and irresponsibility of some in the banking sector has created massive economic injustice. That said, not all criticism of the finance industry is warranted. While the disgruntled and the nihilistic think of the financial sector as nothing more than a cynical money-making operation, this sentiment – while understandable – fails to capture just how critical the financial sector is for a functioning society and humanity’s well-being.

Take a minute to consider your setting. Are you in your home? If so, think about how you purchased it. Did you take out a loan? If so, where did this loan come from? Presumably it came from a bank, which in turn sourced the funds from its depositors – workers and institutions active in the real economy. If it wasn’t for the bank’s fundamental linkage to the value-creating people and companies responsible for a functioning economy, its lending system could not be sustained and the loan which financed your home may never have happened.

By balancing incentives for lenders and borrowers, the financial sector is able to both contribute to – and benefit from – productivity in the real economy. Consequently, the supply and demand dynamics that shape society, and the financial institutions that operate within it, are inseparable.

DeFi’s value proposition

At the moment, no one is buying a home with blockchain loans. Municipalities aren’t funding infrastructure development with crypto. Corporations aren’t financing mergers and acquisitions with lending decentralized autonomous organizations (DAO). All of this begs the question: From where does DeFi derive its value?

The truth is that the basic value proposition of crypto - as it is currently constituted - is unsustainable and, arguably, Ponzinomic. “Line-go-up” isn’t a genius financial strategy when the only thing underpinning this view is the expectation of exponential growth. While advocates of the status quo point to the use of increasingly complex strategies within the DeFi space, the truth remains that DeFi can generate long term value only when people - and money - enter the space from the “real” economy.

As we’ve seen the number of DeFi users stagnate, and its total value locked decline, it is clear that widespread popular adoption isn’t happening on its own. Without a fundamental raison d'etre, DeFi looks less like a financial revolution and more like a pyramid scheme. To build lasting value, DeFi needs to focus on economic integration, not selling steak knives. We will not see sustained DeFi growth until markets see blockchain as a system compatible with the requirements of real world economics

Making DeFi work in the real economy

While it is clear that DeFi needs real-world use cases, it is less clear how exactly to create them. However, a necessary first step is to completely transform how DeFi conducts risk assessment. It is no secret that people are dissuaded from DeFi because of its association with financially risky activities.

For example, the borrowing and lending facilitated by Celsius Network and other discredited lenders was conducted with the purpose of placing directional bets on the price of various crypto assets. These lenders had no arbitrage strategy and the interest rates these lenders charged – which, under a functioning financial system, would have accounted for risk, were essentially arbitrary.

Read more: What Is DeFi?

The solution to this freewheeling “YOLO lending” is to create objective risk assessment mechanisms. For example, traditional finance (TradFi) uses yield curves based on “risk-free” U.S Treasury debt to assess the systemic risk in the bond markets at any given time. A DeFi-native version of a yield curve would be able to assess the risk inherent across a protocol. Similarly, blockchain debt rating tools, functioning in a similar manner to those from Moody’s or Fitch, could assess the risk profile of any one lender and rate the integrity of blockchain debt. Without the foundations of a credit system or the financial infrastructure and plumbing to service lending markets, DeFi debt markets have nowhere to grow.

While not sufficient, these tools would mitigate industry fears about DeFi’s purported instability. By laying the ground for objectively derived and sustainable interest rates, DeFi protocols would be able to provide the predictability necessary to facilitate real world lending, and in turn, real-world use cases.

DeFi’s speed, autonomy and transparency would greatly benefit a number of financial subsectors, from mortgages to corporate M&A to countless other enterprise use cases. However, these are not sufficient attributes in and of themselves to align DeFi with the requirements of mainstream finance. Instead, the DeFi industry needs to demonstrate its maturity by taking the concerns of mainstream institutions seriously. Failure to do so will only exacerbate DeFi’s decline.

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Brent Xu

Brent Xu is Chief Executive Officer and Co-founder of Umee, a Web3 bond-market platform. Brent was one of the first employees at ConsenSys and played a role in early Ethereum development. He also led strategy at Tendermint, set the strategic roadmap and partnerships for the Cosmos Ecosystem, and prior to that, traded bonds on Wall Street.