TradFi: We’ve been witnessing some serious jitters in the TradFi markets as global investment giant, Credit Suisse saw soaring prices for its Credit Default Swaps — insurance against the bank defaulting on its loans — and its stock price plummet to levels not seen in over a decade. All of this after the British Pound plunged to record lows due to a mini-budget presented by the new government.
It seems that far from providing stability, traditional markets, as well as some of the most recognizable brands, are once again facing a mounting credibility problem. Since the 2008 Global Financial Crisis, traditional institutions have struggled to regain and rebuild systemic integrity, trust, and credibility in the global financial markets.
But this isn’t 2008, we have DeFi now. As Aave founder and CEO Stani Kulechov tweeted: “First Celsius proved why DeFi is needed, Now Credit Suisse is going to prove why DeFi is going to stay.”
DeFi Vs TradFi
DeFi lenders like Aave and MakerDAO issue loans based on smart contracts that liquidate automatically, so risk management is coded in, and not reliant on fallible humans. The smart contract issues over-collateralized loans and allows them to continue as long as a specific loan-to-value (LTV) ratio is upheld.
Part of the reason for the liquidity crunch resulting from the bankruptcy of Three Arrows Capital earlier this year, was the sheer scale of under-collateralized, and in some cases uncollateralized, loans. DeFi can help prevent this. Good luck trying to persuade a smart contract to provide a dodgy loan in exchange for an invite to your yacht party next weekend.
With DeFi, if the price of a borrower’s collateral falls due to the extreme market movements we saw in June, smart contracts liquidate automatically so the protocol and liquidity providers are safe.
In June, Celsius froze withdrawals for hundreds of thousands of customers because it had issued loans without proper risk management procedures, leaving it with a $1.2 billion hole in its balance sheet. Aave and MakerDAO, were able to use DeFi smart contracts to navigate the turbulence and ride out the wave.
Because smart contracts are programmed to only issue over-collateralized loans, there’s no risk of creditors defaulting. So there’s no market for CDS-type instruments, removing the ability for investors to bet on the solvency of the protocol.
There would be little point betting on the solvency of a DeFi protocol anyway, because all the details including its assets, cash flow, and governance are recorded on the blockchain and open for anyone to review. This transparency means that platforms like Dune Analytics and Token Terminal can create live, real-time data charts showing the entire financial story and situation of any on-chain protocol.
This detailed data is often obscured or massaged in traditional financial organizations and released on a quarterly or year-end basis. By the time the information is in the hands of clients, it’s often too late to respond.
This is part of the reason Credit Suisse’s investors have been jittery: they don’t have enough real-time, available data to prove or dispel any market rumor. In a clear example of the tail wagging the dog, the confusion and fear that results from this lack of transparency causes a rush for the exit and creates the very problem the investors imagined in the first place.
Can DeFi solve the TradFi transparency issue?
Complete, real-time transparency is one of the much-needed innovations being brought to the market by DeFi and, unlike traditional banks, taxpayers will not be forced to bail out DeFi protocols if they fail. DeFi insurance is available to protect investors, and the taxpayer is safe.
DeFi is by no means perfect, it’s still evolving. However, as traditional financial institutions struggle, DeFi is showing a clear way forward with many improvements on the current model that better suits the digital world.
This opinion piece on TradFi can be followed on Twitter: @NathanWrites