Defi- Is DeFi Based on a False Premise?

Published in

Cent Finance

6 min readSep 15, 2021

So… With all the talk and HYPE — is DeFi Based on a False Premise?

About a year ago, a Redditor asked the question ‘Is DeFi based on a false premise?’. Before immediately shutting them down with blind bias towards DeFi, we want to explore the points that were raised and see if we can shed any further light on them. They might, in fact, provide some truth in their perspective.

Here’s what the Redditor said:
“I’m a huge fan of the various DeFi protocols (MakerDAO, Compound, dYdX, Dharma and many more) that have sprung up on Ethereum — they show the power of composable protocols, smart contracts and retail finance.”
“However, one concern is that their success all seems to be based on the supposition that the value of ETH will rise (over the long term). Whilst this may be true for a while (or not ;-)), presumably at some point the value of ETH will stabilise.”
“Interest rates (e.g. for DAI, USDC) and DAI itself are based on over-collateralisation which really only makes sense if you’re expecting the underlying to appreciate in value (or there is some value to holding the underlying, i.e. it is a house you can live in). Without that AFAICT protocols like MakerDAO & the other lending protocols don’t really make any sense to use.”

What are their concerns around DeFi?

So, let’s pull out and dissect the concerns in his post:

Success is based on ETH value appreciation or that eventual stabilisation is ‘presumable’
Interest rates are based on over-collateralised assets that rely on value appreciation
Protocols like MakerDao don’t make sense unless prices increase or there’s a secondary value to holding

Does DeFi rely on ETH appreciation?

Well, the fact is this, the Ethereum blockchain runs on a Proof-of-Work (PoW) consensus, just like Bitcoin, requiring miners with mining equipment to solve mathematical equations that validate transactions and dish out rewards.

At some point, however, the developers behind the Ethereum blockchain realised that an alternative consensus, the Proof-of-Stake (PoS), would allow them to move past energy-intensive mining and instead allow ETH holders to validate transactions themselves (with an alternative reward system). This mining process requires 32 ETH, but that’s not what we’re interested in here, it’s what ETH’s PoS permits — a whole new DeFi ecosystem.

Decentralized Finance, DeFi for short, works towards mimicking and improving traditional financial products, like loans, and interest-bearing savings accounts. The products are called decentralized apps, but 99% of the time you’ll see them being called dApps. The Ethereum blockchain allows these dApps to exist, giving crypto enthusiasts access to new and exciting financial products, and using ETH as the utility token, paying small ‘gas’ fees along the way. At least, that’s the theory. In reality, ‘gas’ is not cheap. Currently, the network fee for ETH for a regular transfer is $8.48, though it changes every day, and on some dApps (when the ETH price was at its peak) users were quoted more than $1,000 for a transaction. This, clearly, is unsustainable.

What happened when ETH price appreciated is that more people wanted to sell it, to trade it, to buy the dips and troughs, to capitalise on the DeFi products, to unlock their staked positions, and basically do anything they could to ensure they were winning and not losing. This resulted in a crazy increase in activity on the network. It was chaotic, and ETH mining fees flew up because the blocks still get mined at the same speed and there simply weren’t enough miners to handle the situation.

As for eventual stabilisation, this is highly unlikely for a deflationary asset with a fixed circulating figure, as it can’t be minted and burned at will, like with fiat currencies.

Concern: Debunked

Answer: A stable ETH price and a strong network of miners is what DeFi depends upon

Interest rates are based on over-collateralised assets which rely on value appreciation

Let’s try and keep this super simple.

When you take out a crypto loan, you will have to collateralize it, which means you lock in your own crypto and in exchange they give you either a different cryptocurrency, some fiat currency or a stable coin. Typically, your collateral will be 50% of the total value locked (TVL), though you may find 20%, 30%, or 70% on other platforms. This means if you want to loan $50,000, you’ll need to place $100,000 worth of crypto to get it.

When you first look at this, you might just ask ‘Why not sell half of the crypto to get the $50,000?’. Well, that’s because most cryptocurrencies are deflationary and those who hold a long position in crypto believe that the $50,000 will be worth a lot more by keeping it as crypto than by spending it (they’re generally right). However, they might still have fiat currency needs and are willing to take the risk of locking up their digital assets.

Now, these loan markets are two-sided , so as well as taking out a loan, you can be the one to provide the liquidity to the platform in exchange for fixed returns. You add your crypto to a pot and earn a 4% or 5% return per year, which is a cut of the interest rate fee applied to the loanee’s payback agreement. If the loan recipient fails to pay back the loan, or the value of the crypto collateral drops to a certain level before full payment is made, the Smart Contract executes its function and both parties — are returned the remainder of their funds.

In terms of our original example, that means if you collateralized $100,000 of crypto to get $50,000 of USD, and then the $100,000 drops in value to less than $50,000, the loanee keeps the USD and the lender keeps the crypto (or the individual if it’s a P2P loan).

Concern: Correct

Answer: That’s exactly what you agree to when taking the loan! There’s also a risk when taking a loan from a bank, but they might come and take your house…

Protocols like MakerDAO don’t make sense unless prices increase or there’s a secondary value to holding

Some analysts believe that DAI only works if ETH continues to increase in price forever. This is a pretty natural conclusion to come to because the price of ETH has increased considerably over the last couple of years and at the same time MakerDAO has flourished.

The reality, however, is that ETH/USD price relationship and MakerDAO system collateralization ratios show very little correlation. Crypto movements don’t always relate to macro or microeconomics, there are other forces at play. In this case, yes, as ETH prices go up, DAI becomes more useful and can help users to make more money, however, even when ETH prices drop, the ability to collateralize other assets means ETH is not the be-all-and-end-all of DeFi. We don’t think Ethereum’s Developers want that pressure on the network either, it’s more likely that they just wanted to get the ball rolling on DeFi.

In terms of the underlying asset holding more value in terms of utility, this could be found in terms of an NFT. You could stake your NFT for ETH, then provide the ETH as collateral for a loan. Later, you pay back the loan to get the ETH, and collect your NFT, which you believe will be more useful at a later date. For example, your NFT might be used for an art show in 6 months time, and you need to release the value now — a crypto loan could be of great use.

Concern: Partially correct

Answer: When prices are not increasing, there are alternative actions to take

So, is DeFi based on a false premise?

The premise is that innovators can build an exciting and innovative financial ecosystem that disrupts traditional finance and changes the world, all of which is true. The notion of a false premise is FUD (fear, uncertainty, doubt). We are still at the beginning of this adventure. It will be interesting to see how this industry will look in 5 years…