Decentralised Finance (DeFi) is a new way of reshaping the world financial system with a global market of more than $200 billion total amount of value locked (TVL). It is, however, an irony that despite taking lessons from the past, the world is on the verge of yet another global economic crisis and this emerging decentralised finance market is largely contributing to it. Let us delve deeper into the technical details of DeFi and see how it can become the root cause of the global recession.
The existing global financial system is centralised and controlled by governments and regulatory bodies. International financial institutions such as the World Bank, International Monetary Fund, Asian Development Bank, and European Investment Bank dominate the economies by lending money to reduce poverty.
Money is created under the supervision of governments. Stock exchanges, insurance companies, central banks, and securities exchanges also play a pivotal role in the current financial infrastructure. However, one may find several problems in the existing financial system.
These problems include the involvement of middle-man or third parties, lack of transparency, the influence of government on the monetary policy, monopoly of multi-national companies in the international market, monopoly of the dollar, the difficulty of developing countries to freely participate in the international markets, and wealth inequality, just to name a few.
Decentralised Finance is not based on real assets and has nothing to do with the real economy
DeFi, as claimed by its proponents, is the panacea to all these problems. Simply speaking, DeFi says to remove the role of this ‘centralised’ entity from the existing global financial system and redesign the global financial system from scratch by considering the ‘decentralisation’ aspect.
Let’s understand this with an example. A company wants some money to extend its business. This company will contact the bank and request a loan. Bank authorities will perform necessary checks and issue the money with a certain interest rate. However, the money the bank has given to this company is created by the government (central bank) using Fractional Reserve Banking System.
In essence, reserve requirements are necessary for this system to operate. However, in the context of DeFi, this company can become its own bank and get credit from code on a blockchain. No institution is required. Imagine a world where everyone becomes their own bank, create credit, and launch their own financial product and services, all without any control and regulation. How fragile the system will be?
Flash loans, stablecoins, stacking/lending/borrowing, pegged tokens, decentralised exchanges, non-fungible tokens (NFTs), smart contracts, dApps, and cryptocurrencies are the building blocks of DeFi — all using blockchain as an underlying technology.
DeFi is based on peer-to-peer (P2P) transactions (designed mainly on Ethereum). In principle, P2P transactions should reflect real economic activity. However, this is not the case with DeFi. Can you imagine a digital picture worth $69 million?
One of the most expensive NFT is “Everydays: the First 5000 Days”, which is a digital work of art contains 5,000 images but it is not backed by any real asset. Moreover, such trading of NFTs only reflects the bragging rights and not the actual ownership of the digital asset in legal terms.
Cryptocurrency, on the other hand, in its essence, does not have any intrinsic usufruct and utility. These are just numbers (imaginary) fed into the computers and have nothing to do with the real economy. Due to the high volatility in cryptocurrency prices, people use it for investment purposes, as returns are high in a very short period.
A study, ‘Post-Crisis Reforms: Some Points to Ponder’, presented in 2010 at the World Economic Forum following the global financial crisis of 2007-08, reveals four basic factors that caused the great recession: (a) diverting money from its basic function to act as a medium of exchange, and making itself an object of trade, (b) huge penetration of derivates, (c) sale of debts, and (d) short sales and blank sales in stocks, commodities and currencies. History is repeating itself. The same causes are present even at a large scale in the DeFi ecosystem.
Fabio Panetta — renowned international economist and member of the Executive Board of the European Central Bank — said in his recent speech at the 22nd Bank for International Settlements (BIS) Annual Conference, June 2023, that crypto is creating new narratives to attract new investors.
This DeFi ecosystem is among one such narrative to give new blood to crypto, or in a broader sense, it can be considered as a rebranding of the crypto ecosystem. The very purpose of DeFi is to support a crypto asset-based economy. It serves as a fuel to boast market penetration of crypto asset-based products.
According to researchers, the current DeFi system relies heavily on centralised intermediaries such as wallet providers, oracles, mining pools, and blockchain API providers. Thus, DeFi’s claim of decentralisation is not 100 per cent correct.
One cannot leave DeFi ecosystem as caveat emptor. This is to say that investors invest at their own risk. DeFi is an unregulated, uncontrolled balloon that can burst at any time. It is not based on real assets and has nothing to do with the real economy. The proponents of DeFi ecosystem, including crypto investors, made these DeFi instruments just to keep alive crypto.
Even with Markets in Crypto Assets (MiCA) regulation, EU governments want to show that they do not support trading and investment activities of unregulated and unbacked crypto assets. Regulators should control DeFi ecosystems, prohibit people from investing in DeFi tokens, and discourage media campaigns — the new EU MiCA regulation does the same in the context of crypto-assets. Additionally, DeFi ecosystems are unbridled, thus leading to bankruptcy, scams, and economic turmoil.
There is a colossal mismatch between a real asset-based economy and an imaginative economy — which showed its disastrous effects previously, and the same is again happening through DeFi.
One should ponder on an excerpt written by Justice (retd.) Muhammad Taqi Usmani, in the historical judgement on Riba by the Supreme Court of Pakistan, in the context of DeFi: “The whole economy of the world has thus been turned into a big balloon that is being inflated on daily basis by new debts and new financial transactions having no nexus whatsoever with the real economy. This big balloon is vulnerable to market shocks and can be burst any time.”
The writer teaches Computer Science at Munster Technological University (MTU), Ireland.
X (formerly Twitter): MRehmani
Published in Dawn, The Business and Finance Weekly, November 6th, 2023