Casual Thoughts on the State of DeFi
As crypto markets are a bit bloody at the moment it seems like a good time to reflect on recent trends as we continue to build into the future.
Decentralized finance ideally should be built on solid principles and transparent risk management. I honestly have not seen too many projects that have this as the primary focus, which hopefully changes in the future.
Risk profiles on many of the instruments in Decentralized Finance have largely been ignored or in some cases are completely unknown, which has created an environment where users are just chasing the highest APY with a generally reckless disregard for the risks they are inheriting. Which is simply put, insane and unsustainable.
I think the first thing that we examine is the fact that ERG exists in an inherently volatile industry, in unprecedented macro conditions.
In accepting this reality the concept of over-collateralization becomes an increasingly important construct that serves as a solid foundation for decentralized frameworks. If we are going to build financial tools that last, over-collateralization and transparent assumptions are vital.
There is some trade-off with short-term capital efficiency, however, longer-term sustainability should ultimately be the goal. Decentralized networks are by nature less efficient than their centralized counterparts. However, the benefits of trustless environments for many offers value beyond the efficiency tradeoffs.
Ergo is Proof of Work, we start with a 0% rate market. Any protocol that is building a financial product offering some form of yield does not need to compete with a set protocol rate which is an advantage for bootstrapping organic growth. Mined ERG has no set rate of return other than changes in the market rate. This environment is ideal for bootstrapping low-yielding instruments that are transparent, adequately backed, and most importantly trustless.
Trustless here is a combination of open/transparent assumptions, well-designed contract implementations, and decentralized assumptions.
We have been seeing the implosion of products built on poor assumptions and inadequate backing, and products that leverage centralized custodial trust are having issues as well. As an industry, we can do better.
Protocol governance may serve a purpose in the initial bootstrapping of new Defi products and frameworks, however, recent events have shown the risk of central entities. Having an asymmetrical information advantage due to a lack of transparency and trading against communities is always a risk, beyond exploiting governance powers directly. Personally, I think the ideal for core economic frameworks in a decentralized ecosystem is to move towards immutability with transparent risk assumptions and clear exit routes.
One factor that also should be taken into consideration is avoiding external risks beyond the native protocol itself. I could use SigUSD, the stablecoin on Ergo as an example.
Within the Ergo ecosystem, SigUSD has full liquidity. It is redeemable via contract at the set rate. However, if it were to move beyond the ecosystem the liquidity of a potential stablecoin pair would be dependent on market making, continually circulating liquidity to exchanges with the intent of preventing slippage in order books. The underlying dynamics of SigUSD are not designed for this. So why inherit additional risk?
Decentralized Finance should be built with principles that are hyper-focused on long-term survivability, and are open and accessible to everyone.
I see many networks attempting to mimic properties of centralized systems, sacrificing the inherent inefficiency of decentralization often leads to the same old challenges centralization has always brought about.
I see many decentralized finance protocols attempting to mimic traditional markets, which is leading to the same old challenges traditional markets have always brought about.
If collectively we create a suite of products that are built on solid principles the success is not necessarily assured however the risk assumptions will be known and better systems can come about.
It is temporarily more profitable to build systems with no tolerance for risk assumptions. However, the long-term viability of products with this intent has proven to be very questionable.
For decentralized finance to have a future need to get back to core principles, transparent security assumptions, open uncensorable participation, and systems designed with the assumption they will be attempts to exploit the framework and extract value.
When we have a lack of transparency, barriers to entry, custodial services, and frameworks that are designed to extract value vs preserve value we probably are worse off than traditional markets for at least traditional markets have some oversight and guardrails.
Defi 1 seemed to be tokenizing to offset the prospect of an impermanent loss.
Defi 2 seemed to be gamifying tokenomics to capture emission inflation.
Both of these are fairly questionable in terms of the longer-term value.
Hopefully, as things deleverage we reset back to the basic principles that gave birth to the crypto movement.
Manage your risks and trade well.
This is not an official position of the Ergo Foundation, rather casual thoughts as I watch the current state of markets.