🇺🇸 English version
Does decentralized finance (DeFi) aim to replace traditional finance? It certainly sets itself apart with several innovations enabled by its decentralized nature.
Embracing the usual functions of traditional finance—fund transfers, asset and derivatives trading, collateralized and uncollateralized lending, and investment vehicles—DeFi seeks to streamline these services by directly connecting parties through smart contracts. The absence of intermediaries, traditionally supposed to ensure the regularity of operations and the stability of the system, is compensated on one hand by a governance aiming to monitor the platforms' evolution, and on the other hand by much stricter rules regarding loan collateralization. While banks must hold a fraction of their risk-weighted assets in equity, DeFi platforms, lacking any last-resort lender or government guarantee, must over-collateralize the loans they grant. Thus, each cryptocurrency loan must be secured at 150%, especially to counter the sometimes substantial fluctuations in these assets' values. Moreover, to ensure the system's viability, smart contracts are put in place to automatically liquidate positions when the value of the collateral falls below a certain threshold (above 100%). In this way, for a flash loan—immediately repaid and a unique product to DeFi—the repayment is ensured even before the loan is granted.
This highlights a fundamental characteristic of DeFi: investments made almost purely on the arbitrage between cryptocurrencies with variable exchange rates, and stablecoins pegged to fiat currencies, make this ecosystem largely decoupled from traditional financial markets. Even though the majority of stablecoins are backed by currencies whose reserves are managed off-chain, this setup is transparent to DeFi users, who focus solely on arbitraging between the values of cryptocurrencies. As of Q1 2022, the total capitalization of DeFi amounted to 141 billion dollars.
For this system to function in a closed loop, it had to be enriched with a number of services enabling exchanges between cryptocurrencies, lending, purchasing derivatives and crypto-assets, and the pegging of stablecoins. All these applications constitute what is called the "DeFi Lego," through which the same asset transits from one service to another, sometimes cyclically, for example, by borrowing an asset to serve as collateral for another loan.
DeFi, therefore, naturally lends itself to levels of leverage usually prohibited in traditional finance.
In a bullish market, this allows for substantial gains. However, in a panic, it's very easy to trigger a "death spiral," during which the entire collateralization system collapses in a domino effect. This risk is further increased by the youth of DeFi, making it particularly vulnerable to the irrational behavior of opportunistic actors. Algorithmic stablecoins, whose value is not pegged to fiat but to a reference cryptocurrency, have not yet found the right formula to protect against the risk of sharp depreciation following market panic.
The most recent example is Terra/Luna, which relied on an arbitrage mechanism between the stablecoin UST (Terra), whose value is determined by its supply, and a trading system with another currency, Luna. If the UST supply was too low, its value exceeded one dollar, creating an arbitrage opportunity to sell it and buy Luna, whose value then increased while that of UST decreased. A new arbitrage cycle thus began in reverse, keeping UST around a dollar. The incentive to hold Luna to initiate the process was due to interest rates of 20% per annum, requiring constant and sustained growth in the number of users to maintain the system. A few massive sales of UST were enough to trigger a total loss of confidence in Terra/Luna, which the algorithm failed to stop but rather amplified, leading to combined losses of 40 billion dollars.
For DeFi to develop and mature, the search for more ingenious algorithms and incentive mechanisms must continue. However, the real blossoming of DeFi will likely only occur when the crypto economy truly merges with the real economy, and cryptocurrencies cease to be purely speculative assets to become genuine means of payment.