Decentralised Finance’s speculative nature – Business

Decentralized Finance (DeFi) is a new way to reform the global financial system with a global market worth more than $200 billion (TVL). It is ironic, however, that despite lessons from the past, the world is on the brink of a new global economic crisis, and this emerging decentralized financial market is largely contributing to that. Let’s delve deeper into the technicalities of DeFi and see how it could become the root cause of the global recession.

The existing global financial system is centralized and controlled by governments and regulatory authorities. International financial institutions such as the World Bank, the International Monetary Fund, the Asian Development Bank and the European Investment Bank dominate economies by lending money to reduce poverty.

Money is created under the supervision of governments. Stock markets, insurance companies, central banks and stock exchanges also play a crucial role in today’s financial infrastructure. However, several problems may arise in the existing financial system.

These problems include the involvement of intermediaries or third parties, lack of transparency, government influence on monetary policy, the monopoly of multinational companies in the international market, the monopoly of the dollar, the difficulty of developing countries to participate freely in international markets, and wealth inequality, to name a few.

Decentralized finance is not based on real assets and has nothing to do with the real economy

DeFi, as its proponents claim, is the panacea for all these problems. Simply put, DeFi says that we need to remove the role of this “centralized” entity from the existing global financial system and redesign the global financial system from scratch by considering the “decentralization” aspect.

Let’s understand this with an example. A company wants some money to expand its operations. This company contacts the bank and applies for a loan. The banking authorities will carry out the necessary checks and issue the money at a certain interest rate. However, the money given by the bank to this company is created by the government (central bank) using the Fractional Reserve Banking System.

Essentially, reserve requirements are necessary for this system to function. However, in the context of DeFi, this company can become its own bank and get credit from code on a blockchain. No setting is necessary. Imagine a world where everyone becomes their own bank, creating credit and marketing their own financial products and services, all without any control and regulation. How vulnerable will the system be?

Flash loans, stablecoins, stacking/lending/borrowing, pegged tokens, decentralized exchanges, non-fungible tokens (NFTs), smart contracts, dApps and cryptocurrencies are the building blocks of DeFi – all using blockchain as the underlying technology.

DeFi is based on peer-to-peer (P2P) transactions (mainly designed on Ethereum). In principle, P2P transactions should reflect real economic activity. However, this is not the case with DeFi. Can you imagine a digital photo worth $69 million?

One of the most expensive NFTs is ‘Everydays: the First 5000 Days’, a digital work of art that contains 5,000 images but is not backed by any real assets. Furthermore, such trading in NFTs only reflects bragging rights and not actual ownership of the digital asset in legal terms.

Cryptocurrency, on the other hand, essentially has no intrinsic usufruct and utility whatsoever. These are just (imaginary) numbers that are entered into the computers and have nothing to do with the real economy. Due to the high volatility of cryptocurrency prices, people use it for investment purposes as the returns are high in a very short period of time.

A study, ‘Post-Crisis Reforms: Some Points to Ponder’, presented at the World Economic Forum in 2010 following the 2007-2008 global financial crisis, reveals four fundamental factors that caused the Great Recession: (a) diverting money from the economy; basic function of acting as a medium of exchange and making itself an object of trade, (b) massive penetration of derivatives, (c) selling of debt, and (d) short sales and blank sales in stocks, commodities, and currencies. History repeats itself. In fact, the same causes are widely present 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 annual conference of the Bank for International Settlements (BIS), June 2023, that crypto creates new narratives to attract new investors Pull.

This DeFi ecosystem is one of those stories of bringing new blood to crypto, or in a broader sense it can be considered a rebranding of the crypto ecosystem. The goal of DeFi is to support a cryptocurrency-based economy. It serves as fuel for the market penetration of cryptocurrency-based products.

According to researchers, the current DeFi system relies heavily on centralized intermediaries such as wallet providers, oracles, mining pools, and blockchain API providers. So DeFi’s claim about decentralization is not 100 percent correct.

You can’t leave the DeFi ecosystem as a caveat. This means that investors invest at their own risk. DeFi is an unregulated, uncontrolled balloon that could burst at any time. It is not based on real assets and has nothing to do with the real economy. The proponents of the DeFi ecosystem, including crypto investors, have created these DeFi instruments just to keep crypto alive.

Even with the regulation of Markets in Crypto Assets (MiCA), EU governments want to show that they do not support the trading and investment activities of unregulated and unbacked crypto assets. Regulators should monitor DeFi ecosystems, ban people from investing in DeFi tokens and discourage media campaigns – the new EU MiCA regulation does the same in the context of crypto assets. Furthermore, DeFi ecosystems are rampant, leading to bankruptcies, scams, and economic turmoil.

There is a colossal discrepancy between a real asset-based economy and a fantasy economy – which previously showed disastrous consequences, and the same thing is happening again through DeFi.

One should reflect on an excerpt written by Justice (retd.) Muhammad Taqi Usmani, in the landmark judgment on Riba by the Supreme Court of Pakistan, in the context of DeFi: “The entire economy of the world has thus turned into a big One balloon that is inflated daily by new debts and new financial transactions that have no connection with the real economy. This big balloon is vulnerable to market shocks and could burst at 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 6, 2023