DeFi, which is largely based on centralized stablecoins, could have collapsed without the intervention of the Fed. A shame for an ecosystem built in opposition to traditional finance.
In a few days, many went through all the emotions. Stupor, fear, anger and relief, sometimes several at the same time. While everyone was chained to the hardships of Silvergate Bank, which has since called for its liquidation, it was the administrative closure of Silicon Valley Bank (SVB) by the California authorities on Friday, March 10, that rocked the global economy. The US Federal Reserve (Fed) initially decided not to intervene, and we feared a global catastrophe.
Finally, to avoid contagion and a major crisis, the Fed changed its mind and decided to guarantee 100% of deposits. This guarantee, among other things, relieves Circle, the USDC stablecoin issuer, which lost parity with the dollar over the weekend. If everything is back to normal and the crypto market has even taken off, this nevertheless exposes the structural weaknesses of the sector and decentralized finance (DeFi), which, despite being too closely related to traditional finance in themselves.
Problem: DeFi’s dependence on traditional finance
Necessary distinction between protocols and tokens
The whole problem with decentralized finance lies in its understanding by the general public. Indeed, some confuse the protocols of the tokens offered on these protocols. And the confusion increases when we know that some of these tokens are native tokens of the protocol in question, such as Uniswap’s UNI.
Decentralized finance is basically a set of liquidity pools into which certain users deposit their cryptocurrencies so that they can then be loaned to others. It is also an opportunity to exchange one crypt for another without an order book. To guarantee some stability, most of the largest liquidity pools are made up of stablecoins.
The problem is that this market is under pressure from three stablecoins: USDT, USDC and DAI. The first two are two centralized stablecoins, and the third, which is nevertheless decentralized, is basically guaranteed by… USDC. This is why DAI suffered the same fate as USDC on the weekend of March 11 before returning to normal.
End of UST, Reinforcement for Centralized Stablecoins
Therefore, a solution has been found a priori: we must get rid of centralized stablecoins. Indeed, the latter are actually guaranteed by their issuing company. For example, Tether for USDT, Circle for USDC, and Paxos for BUSD, although the latter may be in its last months as the US financial regulator asked Paxos to stop issuing a stablecoin from Binance.
The best guarantee is to have $1 in your bank account for every stablecoin issued. So if there are 10 billion stablecoins A, the company issuing stablecoins A must have $10 billion in one or more bank accounts. This allows you to execute exchange requests.
The problem is that getting rid of centralized stablecoins is far from easy. The main reason is the collapse of UST in May 2022, which was a purely algorithmic stablecoin, guaranteed by automated arbitrage mechanisms between UST and LUNA, the Terra ecosystem token. Trust in these stablecoins was lost and then security was introduced by centralized stablecoins.
Solution: The Emergence of Purely Decentralized Solutions
Structural dependency of DeFi on centralized stablecoins
As such, DeFi relies on liquidity pools primarily made up of centralized stablecoins. In other words, decentralized finance depends on centralized finance. Therefore, the custodian banks for Tether and Circle must be in good financial condition. Their bankruptcy can lead to the fall of the ecosystem that was supposed to free itself from them.
Some dispute this dependency, starting with bitcoin maximalists who make little use of decentralized finance. It’s really not normal that there are such important connections between traditional finance, which Satoshi Nakamoto denounces in his white paper, and the crypto ecosystem.
However, today the damage has been done. Decentralized finance is completely dependent on centralized stablecoins and therefore on banks. At the time of this writing, these stablecoins were talking about a capitalization of about $100 billion (including DAI), or 10% of the crypto market capitalization.
The Necessary Emergence of Algorithmic Solutions
The main problem was mentioned in our previous article: a banking crisis with a cascade of bankruptcies will lead to the likely end of decentralized finance as we know it today. Therefore, some are calling to get rid of this dependence on centralized stablecoins in order to make room for decentralized stablecoins.
There are few of them on the market today. First, we have DAI. But the issuer has chosen to secure the majority of the DAI in circulation with the USDC. We also have USDD from Tron, FRAX from Frax Finance or AMPL from Ampleforth. However, no one has managed to find a place in decentralized finance protocols.
Is it just a matter of popularity? Is it more of a lack of trust in these stablecoins? However, it seems important that algorithmic stablecoins outperform centralized stablecoins in order to reduce, if not end DeFi’s dependence on the banking sector.