- Bank of International Settlements’ economists said current DeFi loans don’t finance real economy activities
- Total value locked in DeFi lending protocols reached $50 billion in early 2022, up from nearly zero at the end of 2020, according to BIS data
The recent Terra LUNA collapse and Celsius’ restrictions on withdrawals have sparked fears of a crisis in crypto lending. Economists at the Bank of International Settlements (BIS) said while on-chain collateral in DeFi lending overcomes asymmetric information, it doesn’t make the space immune from boom-bust episodes, compounded by liquidation spirals.
Cryptocurrency lending platforms — where borrowers can deposit cryptoassets as collateral to secure a loan from the lenders — are critical to the DeFi (decentralized finance) ecosystem, according to the institution’s bulletin released this week. However, BIS economists found these platforms’ institutional features mostly “facilitate speculation in cryptoassets” rather than “real-economy lending.”
“Smart contracts assign each collateral type a haircut, or margin, that determines the minimum collateral borrowers must pledge to receive a loan of a given amount. The high price volatility of cryptoassets means that there is overcollateralization: the collateral required tends to be much higher than the loan size,” the bulletin read.
“As DeFi loans are disbursed in cryptoassets and secured by crypto collateral, they do not currently finance real economy activities,” it added.
Meanwhile, BIS economists believe that the need for collateral blocks the fundamental goal of DeFi: “democratizing finance.” Those not so asset-rich are often excluded when it comes to accessing financial services.
“Due to the anonymity of borrowers, overcollateralization is pervasive in DeFi lending,” the report read. “Reliance on collateral also limits access to credit to borrowers who are already asset-rich, negating financial inclusion benefits.”
As high returns attract investors, the total value locked in DeFi lending protocols reached $50 billion in early 2022, up from nearly zero at the end of 2020, according to BIS.
Now that trend has reversed — total value locked has plummeted along with asset prices.
Is it collateral or opaqueness that’s the problem?
It’s not surprising that a champion of central banks would dismiss the concept of decentralization. But Chase Devens, research analyst at Messari, argues centralization is largely responsible for the current mess, noting that it was poor risk-management mixed with a lack of understanding of asset and protocol functions — such as Terra and stETH — that left large centralized players such as Celsius searching for liquidity.
“The falling dominoes have been fueled by a lack of transparency as to how much leverage was built up within the system,” Devens said.
“As we know, the state of DeFi is publicly verifiable and allows the health of the system to be assessed in real time. However, [over-the-counter] deals and off-chain leverage can build up beyond this ecosystem and trigger surprise liquidation cascades as they are unraveled.”
If DeFi lending wants to make it into the real-world economy, BIS economists suggested it must engage in “large-scale tokenisation of real-world assets” and rely less on crypto collateral. However, “developing its ability to gather information about borrowers,” would eventually lead the system to “gravitate towards greater centralization.”
“The similarities between DeFi and legacy intermediaries are increasing, which has two important implications,” the report read. “The first is that elements of DeFi, mainly smart contracts and composability, could find their way into traditional finance. The second implication is that, once more, decentralization proves to be an illusion.”
Devens agreed that large-scale tokenization has always been a goal for DeFi. Yet, he thought abandoning anonymity and relying on centralization might not be the best strategy over the long term because “centralized entities have proven to be opaque and create bottlenecks of their own,” he said, pointing once more at Celsius.
“Although the identities of the borrowers are (mostly) unknown, we know exactly what price levels will trigger liquidations from on-chain lending protocols such as Maker or Aave,” he said.
“As zero-knowledge technology continues to improve in the coming years, identity and reputation-based lending systems will have room to flourish.”
Protocols such as MakerDAO are specifically focusing on onboarding real-world assets to expand the collateral base of DAI and, by extension, all of DeFi.
“The evolution of crypto will continue to play out for many years to come and ultimately result in an antifragile system that is anchored on decentralization at its core,” he added.
Get the day’s top crypto news and insights delivered to your inbox every evening. Subscribe to Blockworks’ free newsletter now.
The post ‘Decentralization Proves To Be an Illusion,’ BIS Says appeared first on Blockworks.