Motus Capital Management
Motus Missives Vol. 4 | Dumb Contracts
Updated: Sep 22, 2022
Summary: Centralized Finance (CeFi) vs. Decentralized Finance (DeFi)
Participants – CeFi has borrowers, lenders, and intermediaries, while DeFi has borrowers and lenders
Control – CeFi decisions are made by executives (and shareholders), while DeFi is governed by a community of token holders
Incentives – CeFi incentives are to maximize shareholder value, while DeFi incentives are to maximize platform utility
Flow of Value – CeFi revenue accrues to shareholders and employees, while DeFi revenue accrues to platform contributors
Risk Management – CeFi relies on internal controls and external regulators, while DeFi relies on code governed by protocol users
Which is more trustworthy—centralized platforms with poor regulatory oversight reliant on executives with potentially fraught incentives, or a decentralized protocol governed by code and the community that actually uses it?
Centralized Finance (CeFi) – Dumb Contracts
If you have turned on CNBC on any day in the last few weeks you have likely heard the names Celsius, BlockFi, Voyager, and/or 3 Arrows Capital (3AC). These are centralized companies operating in the crypto market that proved to have horrendous risk management over their loan books. Depending on the actor, these companies either a) lent out customer deposits on an unsecured basis, b) used customer deposits to prop trade in order to provide yield to depositors, c) took loans against customer deposits to pay yield, or d) some combination of these. In the case of 3AC, a shop that started with a background in FX arbitrage, they became a VC and portfolio manager, and at one point managed ~$18BN of crypto assets. Their success earned them an aura of infallibility. Celsius, BlockFi, and Voyager all provided significant unsecured loans to 3AC. In the most extreme case, one of these companies had 59% of their loan book to 3AC. 59%! The unraveling of these activities is key driver of why crypto markets sold off in June. To be clear, not all centralized companies in crypto are bad or poorly managed, but these ones deserved to fail. However, projecting their behavior on all of crypto is also irresponsible.
Unfortunately, we now hear talking points such as “Decentralized Finance (DeFi) is not decentralized” or “DeFi is not stable”. These comments show a gross misunderstanding of what DeFi is. Celsius, BlockFi, and Voyager are not DeFi. These are companies that provided services you would expect to see from a bank, without the same regulation, with no concept of risk oversight, and driven by greed and ego. The collapse of Terra and their stablecoin UST also gets lumped in with DeFi. Again, the decisions that ultimately drove its fall were made by a small group of individuals with discretion, not DeFi. It is fashionable to label certain crypto projects as “ponzis”, often done by people who either do not understand what a ponzi is, do not understand crypto, or both. These failed companies were in some cases, actual ponzis. In real DeFi, you can see deposit and loan balances in real-time. With these companies, we only found out after users lost their funds. Transparency benefits all consumers.
Decentralized Finance (DeFi) – Smart Contracts
Smart contracts are self-executing, programmable contracts following “if-then” decision trees. They provide the ability for transactions or agreements to occur between unrelated parties (create trust) without the need for a third party intermediary.
DeFi platforms use smart contracts to allow traditional financial services in a peer-to-peer manner such as interest on savings, collateralized loans, market making, insurance, etc. These platforms do not have a CEO or employees, they are code. DeFi is not capable of engaging in risk seeking behaviors that could lead to insolvency, unless the platform’s tokenholders vote to do so, in a public setting, putting the token itself at risk. The current leaders in DeFi include protocols such as Maker, Aave, and Compound, that amongst other services provide collateralized loans. Even with the volatility we have seen, these protocols processed liquidations in an orderly fashion. They did not fail, they validated their reason for existence with an alignment of incentives, transparency, and trustless nature of code execution.
The reaction to the fall of the centralized parties has followed a familiar path – “This industry needs more regulation!” Fine, the crypto market has asked for clear regulation for years, but regulated companies have a history of taking on excess risk too. DeFi, through the use of smart contracts, is self-regulating. The code is developed to be resilient, allowing users to trust the outcome rather than trusting an intermediary. 3AC and Celsius had large loans on Maker, Aave, and Compound. Those platforms haven’t missed a beat, while large corporate lenders rapidly became insolvent. DeFi protocols got their money back without needing the courts. To us, this all proves to be another example of why consumers will increasingly put their trust in decentralized systems over centralized ones in the future.
“History never repeats itself, but it does often rhyme.”
The chart below is a helpful reminder that the definition of volatility is not restricted to the downside, and the current macro conditions and zeitgeist still call for the benefits that crypto assets can bring to the global economy. Onwards!
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Motus Capital Management
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