defi crash: defi can’t hold a candle for a centuries-old trust-based system called hawala

In the history of dangerous naivety, the decentralized financial mania of 2021 will withstand the boom of secured debt in 2007. It took a financial crisis to make sense of the world CDO, which repackaged risky mortgage bonds to look safer than they were. “CDOs are nothing but massive Ponzi scheme“Said the villain from a fictional story about the collapse in 2008. How much longer will it take to realize that blockchain-based lending is also reckless?”

The idea that one could give up regulated intermediaries such as banks and make a much higher return by borrowing digital assets was a key attraction of decentralized financing or DeFi. But that was before the bloodshed caused by last month’s collapse began cryptocurrency Terra-Luna couple. The attractiveness of TerraUSD money change, a stable coin that promises 1: 1 convertibility in dollars, lies in the return on nearly 20% of TerraUSD deposits. Withdrawal of funds from the Anchor Protocol, the main Defi an app for lending to the blockchain, smashing the coin, and Luna, its sister asset.

Shortly afterwards, creditors Celsius Network and Babel froze their deposits. BlockFi Inc., a Peter Teel-backed lending platform, said it was “completely liquidating or hedging all related collateral” of a large client believed to be Singapore-based Three Arrows Capital, a troubled crypto hedge fund. BlockFi reduced its staff by 20% just as Coinbase Global Inc., the largest US-based digital asset exchange, laid off 18% of its workforce. There is no end to the crypto winter. Of the $ 252 billion in investment funds tied to DeFi’s protocols last December, less than $ 75 billion remains.

Blockchain technology has promised the Impossible Burger version of finance: unsecured lending, the most important ingredient. DeFi market participants are anonymous. “Assessing borrowers’ risk through time-tested methods – from screening banks to reading reputations in informal networks – is therefore not possible,” researchers from the Bank for International Settlements said recently. Thus, loans must be oversecured to compensate for the lack of confidence. But as recent events have shown, Ethereum-backed bitcoin loans can be just as flammable as CDO’s high-quality mortgage bond portfolio.

Compare the fragility of Defi with the strength of hawala, a highly efficient system for moving funds to the Middle East and the Indian subcontinent from the Middle Ages. If DeFi relies on software code to act as a substitute for courts in the performance of contracts, hawala seeks to fill the legal gap with confidence. As Matthias Schramm and Marcus Taube described the institutional set-up in their 2003 paper:

“(Hawala) is able to move large sums of money without resorting to the official banking system and even without keeping accounting notes. Instead, it is based on the trust of the participating countries and its social and religious integration into the Islamic community. ”

Modern regulators hate hawala because users of a multinational, club-like network can easily circumvent anti-money laundering and anti-terrorist financing laws. Still, the way the system works is almost impossible to erase or even detect. Hawala intermediaries often maintain regular banking relationships indistinguishable from legitimate small business accounts.

For better or worse, hawala is a very real product of money transfer – and has been for centuries. In contrast, much of DeFi is just decentralizing kabuki. Crypto Bros speaks volumes about opposing the tyranny of state control and large guardianship organizations, although in reality DeFi cannot even be compared to the success of a premodern alternative in this regard. Hawala arose to circumvent the lawlessness that gripped medieval long-distance merchants; then he learned to live outside – but together with the law.

This is not all. To be a DeFi borrower, you need more crypto collateral than the loan you are looking for. This restricts “access to credit for borrowers who are already rich in assets,” the BIS report said. For DeFi lending to become a major financial inclusion tool, two things need to happen. First, people need to be able to borrow under their real names to establish a pattern of reliable behavior. Second, more real-world assets such as buildings and equipment need to receive digital representations in the blockchain, so that even the less wealthy have initial collateral.

For all the worries about big technology platforms that benefit from user data, fintech does much better than DeFi when it comes to switching on. The machine learning-based model for evaluating the MercadoLibre Inc. online trading platform. is obviously better than what credit bureaus can tell the conventional bank about the creditworthiness of borrowers in Argentina. The same goes for Antpay Co.’s Alipay payment network. in China. Fintech added a wider range of information – for a wider range of potential borrowers – to what traditional lenders could learn about a small group of people within existing banking relationships. This has had a major impact on emerging markets. A jar of Nutella, sold by a mother and pop shop in India, is now telling a potential lender something valuable about its owner’s creditworthiness.

Ignoring information at the borrower level – or losing it in the mazes of financial engineering – does not end well. Consider highly valued senior CDO tranches in which major mortgages were paramount. DeFi must abandon its techno-anarchist utopia and become more real and centralized. Otherwise, DeFi lending will go down in the annals of finance as a failure where hawala has succeeded: an unreliable 21st century technology that loses out on 14th century innovation that thrives on top of trust.

(Disclaimer: Recommendations, suggestions, views and opinions given by experts are their own. They do not represent the views of the Economic Times)

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