Fellow DeFi adherents, let’s slow down on the outrage about GameStop (NYSE:GME) and the traditional finance system (TradFi).
Blockchain and DeFi offer lots of advantages over TradFi, but TradFi is not completely broken and DeFi is not necessarily vastly superior. Two core characteristics make them look very similar in a way that undercuts the criticism and negative judgments against TradFi.
First, DeFi and TradFi both require collateralization, they just implement it in different ways.
Second, just like collateralization can break down in TradFi, DeFi has a significant exploit that lessens the effectiveness of the collateralization requirement. And away we go!
Short selling has been much debated and criticized in DeFi and blockchain circles in light of the short positions and short squeeze on GME. All of the points raised by DeFi maximalists are well-founded but are also well-known in TradFi circles, having been the subject of discussion and regulation for decades. The Securities and Exchange Commission has strict rules on the subject, and market practice not only seeks to enforce those rules but has its own requirements that go further.
The biggest way that the rules and market practice seek to rein in illegal short-selling (including “naked” shorting) is through collateralization. Every borrowing of stock must be collateralized and that collateral is subject to loss if the borrow is not returned. That is, the borrower posts collateral in order to receive the stock to sell short, and the lender keeps the collateral if the borrower does not return the stock upon demand. Moreover, the amount of collateral required is marked to market every night, so the borrower is constantly posting additional collateral as the stock price rises. A short squeeze would not be possible without the collateralization requirement and nightly mark to market. They are why it can become prohibitively expensive to maintain a short position.
On the DeFi side, lots of commentators pretend that everything is free and easy. In reality, DeFi relies on collateralization, including versions of a mark to market requirements.
Maybe we can pretend it is different because DeFi often doesn’t use the term “collateralization,” preferring the term “locking” since the smart contract takes the relevant assets and holds (“locks”) them until the relevant activity is complete. The smart contract refuses to release the assets unless it is certain that the correct, countervailing value has been credited.
This locking mechanism is the reason that the concept of “total value locked” makes sense as one measure of the success of DeFi.
Without locking assets, nothing in DeFi works: not DeFi lending, where assets are locked before the loan is made; not automated market making, where the smart contract locks up amounts of each of the pair of assets being traded; not wrapped BTC, which locks Bitcoin in a smart contract before issuing the token representing that Bitcoin; not even trading on a DEx, where the smart contract locks up the tokens being bought and sold before doing an atomic swap or other exchange between accounts.
We who espouse the benefits of DeFi on blockchain and criticize TradFi need to recognize this parallel. We need to explain how collateralization in DeFi is better because it is instantaneous and controlled by smart contracts rather than left to manual processes where errors (including failures to post collateral or mark-to-market) are more possible. We also need to remind ourselves that a badly programmed smart contract can be just as error prone as manual processes, and with potentially irreversible consequences.
We also should jump down from the high horse of criticizing TradFi for the fact that short interest can exceed total float (that is, there can be more GME sold short than there are GME shares in existence). DeFi’s Achilles heel is yield farming.
It is tough to criticize GME’s massive short interest where, for example, your Dai locked at yEarn becomes yDai that you take to Aave to receive aDai that you take to Uniswap to receive its liquidity tokens that you take to another DeFi protocol and so on, earning yield at each step but locking up no new collateral. This daisy chain all rolls back to the same original locked assets, such that if something happens anywhere along the string, the consequences could be significant. As such, the chain of assets created in DeFi is parallel to the outsized short interest people are complaining about in TradFi when that daisy chain is not nearly as strong as the blockchain on which it is built.
Nothing in this article is intended to express a view on whether TradFi stock shorting, DeFi daisy chains, or the collateralization practices and methodologies in each, are good or bad, compliant or non-compliant, or even sensible. The point is that all of these things exist and everyone should study the parallels before launching their criticisms and especially before participating in the different markets.
Remember, one definition of DeFi is the use of smart contracts on decentralized blockchains to duplicate the products and services of TradFi. Perhaps that includes some of TradFi’s more challenging features as well.
Lee A. Schneider is General Counsel at Block.one, one of the world’s largest blockchain companies and creator of the EOSIO blockchain protocol. In that role, Schneider is responsible for various aspects of the legal function as well as the company’s government affairs initiatives. He joined Block.one after leading the blockchain, Fintech, and broker-dealer practices at two major international firms. Lee has been recognized as one of the leading voices in blockchain-related regulation and compliance and has played a role in structuring several of the largest and most successful blockchain-related projects. Schneider co-hosts the Appetite for Disruption podcast with Troy Paredes and is the contributing editor for the Chambers and Partners Fintech Practice Guide. He is the contributing editor of the Chambers and Partners 2019 Fintech Practice Guide. All views expressed are in his personal capacity and reflect only his personal views and not those of Troy, Chambers, or block.one or its directors, officers or employees. His views do not constitute legal, investment or any other type of advice.