Let’s Not Be So Fast To Decide

Fellow DeFi adherents, let’s decelerate on the outrage about GameStop (NYSE:GME) and the standard finance system (TradFi).  

Blockchain and DeFi supply plenty of benefits over TradFi, however TradFi isn’t utterly damaged and DeFi isn’t essentially vastly superior.  Two core traits make them look very related in a means that undercuts the criticism and unfavourable judgments in opposition to TradFi. 

First, DeFi and TradFi each require collateralization, they only implement it in numerous methods. 

Second, identical to collateralization can break down in TradFi, DeFi has a major exploit that lessens the effectiveness of the collateralization requirement.  And away we go!

Brief promoting has been a lot debated and criticized in DeFi and blockchain circles in mild of the brief positions and brief squeeze on GME.  The entire factors raised by DeFi maximalists are well-founded however are additionally well-known in TradFi circles, having been the topic of debate and regulation for many years.  The Securities and Trade Fee has strict guidelines on the topic, and market observe not solely seeks to implement these guidelines however has its personal necessities that go additional. 

The largest means that the foundations and market observe search to rein in unlawful short-selling (together with “bare” shorting) is thru collateralization.  Each borrowing of inventory should be collateralized and that collateral is topic to loss if the borrow isn’t returned.  That’s, the borrower posts collateral in an effort to obtain the inventory to promote brief, and the lender retains the collateral if the borrower doesn’t return the inventory upon demand.  Furthermore, the quantity of collateral required is marked to market each night time, so the borrower is consistently posting extra collateral because the inventory worth rises.  A brief squeeze wouldn’t be potential with out the collateralization requirement and nightly mark to market.  They’re why it may change into prohibitively costly to take care of a brief place.

On the DeFi aspect, plenty of commentators faux that every part is free and straightforward.  In actuality, DeFi depends on collateralization, together with variations of a mark to market necessities. 

Perhaps we are able to faux it’s completely different as a result of DeFi typically doesn’t use the time period “collateralization,” preferring the time period “locking” for the reason that good contract takes the related belongings and holds (“locks”) them till the related exercise is full.  The good contract refuses to launch the belongings except it’s sure that the right, countervailing worth has been credited. 

This locking mechanism is the rationale that the idea of “complete worth locked” is smart as one measure of the success of DeFi. 

With out locking belongings, nothing in DeFi works: not DeFi lending, the place belongings are locked earlier than the mortgage is made; not automated market making, the place the good contract locks up quantities of every of the pair of belongings being traded; not wrapped BTC, which locks Bitcoin in a sensible contract earlier than issuing the token representing that Bitcoin; not even buying and selling on a DEx, the place the good contract locks up the tokens being purchased and offered earlier than doing an atomic swap or different change between accounts.  

We who espouse the advantages of DeFi on blockchain and criticize TradFi want to acknowledge this parallel.  We have to clarify how collateralization in DeFi is best as a result of it’s instantaneous and managed by good contracts relatively than left to guide processes the place errors (together with failures to submit collateral or mark-to-market) are extra potential.  We additionally have to remind ourselves {that a} badly programmed good contract might be simply as error susceptible as guide processes, and with doubtlessly irreversible penalties. 

We additionally ought to soar down from the excessive horse of criticizing TradFi for the truth that brief curiosity can exceed complete float (that’s, there might be extra GME offered brief than there are GME shares in existence).  DeFi’s Achilles heel is yield farming. 

It’s powerful to criticize GME’s huge brief curiosity the place, for instance, your Dai locked at yEarn turns into yDai that you simply take to Aave to obtain aDai that you simply take to Uniswap to obtain its liquidity tokens that you simply take to a different DeFi protocol and so forth, incomes yield at every step however locking up no new collateral.  This daisy chain all rolls again to the identical authentic locked belongings, such that if one thing occurs anyplace alongside the string, the implications may very well be important.  As such, the chain of belongings created in DeFi is parallel to the outsized brief curiosity persons are complaining about in TradFi when that daisy chain isn’t practically as robust because the blockchain on which it’s constructed.  

Nothing on this article is meant to precise a view on whether or not TradFi inventory shorting, DeFi daisy chains, or the collateralization practices and methodologies in every, are good or dangerous, compliant or non-compliant, and even wise.  The purpose is that each one of these items exist and everybody ought to examine the parallels earlier than launching their criticisms and particularly earlier than collaborating within the completely different markets. 

Keep in mind, one definition of DeFi is using good contracts on decentralized blockchains to duplicate the services of TradFi.  Maybe that features a few of TradFi’s more difficult options as effectively.

Lee A. Schneider is Basic Counsel at Block.one, one of many world’s largest blockchain firms and creator of the EOSIO blockchain protocol.  In that position, Schneider is accountable for numerous facets of the authorized perform in addition to the corporate’s authorities affairs initiatives. He joined Block.one after main the blockchain, Fintech, and broker-dealer practices at two main worldwide corporations.  Lee has been acknowledged as one of many main voices in blockchain-related regulation and compliance and has performed a job in structuring a number of of the most important and most profitable blockchain-related tasks. Schneider co-hosts the Urge for food for Disruption podcast with Troy Paredes and is the contributing editor for the Chambers and Companions Fintech Observe Information. He’s the contributing editor of the Chambers and Companions 2019 Fintech Observe Information. All views expressed are in his private capability and replicate solely his private views and never these of Troy, Chambers, or block.one or its administrators, officers or staff. His views don’t represent authorized, funding or some other sort of recommendation.