We somehow doubted it. Were the alchemic solutions being offered by DeFi really immune to that age-old pattern? It’s for this reason a new paper DeFi Protocol Risks: the Paradox of DeFi, by Nic Carter of Castle Island Ventures and Linda Jeng, a visiting scholar at Georgetown University Law Center piqued our curiosity when it crossed our radar.
The story of financial markets, after all, is one of continuous decentralisation, innovation and engineering to synthesise seemingly risk-reduced returns and free lunches, which usually turn out to be anything but. Crypto is just another part of that story. To be blunt, FT Alphaville’s initial knee-jerk reaction — based on what we should confess was not that much research at all — was that the very idea of decentralised finance being something new or exciting was hugely naive.
From repo markets to eurodollars and commodities, the story always starts with decentralised frameworks arising quite organically, being heralded as amazing wealth generators, then turning risky, then blowing up, then having regulatory forces battle to contain them — usually by centralising their processes and slowing down their growth by forcing expensive checks and balances on the systems. Even so, DeFi, which stands for “decentralised finance”, remains a murky if increasingly hyped up corner of the crypto world.
But it’s their concluding points that really should not be missed, since they speak not just to the heart of the issue that faces of crypto but also to fintech and financial innovation more broadly. Basically, that there really is no free lunch. And, as Grossman-Stiglitz highlighted as far back as 1980, there is also “a fundamental conflict between the efficiency with which markets spread information and the incentives to acquire information”. This means prices will never reflect the information which is available “since if it did, those who spent resources to obtain it would receive no compensation”. Which de facto means if you remove the incentive (a.k.a. cost) to hunt for information, you will get bad prices and thus incur risk. Here in any case is a similar concluding point from Carter and Jeng (with our emphasis): The paper is a dense read, but of course it would be: it’s DeFi. Nonetheless the authors do a good job of explaining the background of the movement, laying out the current landscape and then setting the scene for the risks.
To be clear, Carter and Jeng do see potential in DeFi bringing down the cost of financial services and broadening access. But they are also incredibly realistic about the challenges and risks. Notably, they are also wise to many of the inherent paradoxes of financial systems that we at FT Alphaville are so fond of flagging. Neither Carter or Jeng are openly hostile to crypto, in fact quite the opposite — Carter is a well known advocate of bitcoin and crypto. That their incredibly well researched work should arrive at conclusions that fitted with our base assumptions seemed noteworthy, therefore.
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