Over the past two months, the Indian central bank, the RBI conducted pilots around the digital Rupee or India’s CBDC (Central Bank issues Digital Currency) across both wholesale and retail market transactions. These have in-turn triggered debate around whether this can disintermediate the banking system. Whilst theoretically possible, the fact that the RBI chose banks to be part of the projects, suggests otherwise in practice. Indeed, the basis for the advent of crypto, now being termed ‘Decentralized finance’ or DeFi, was the fact that the current system of financial intermediation has failed. Financial intermediaries are meant to add value to the system by reducing the cost for the user of capital and increasing the returns for the saver of capital. Unfortunately, we seem to have done the opposite. Worse we create bubbles, scandals, frauds and seek bailouts. Hence, the outcry for a new world. However, this blog talks about why any attempt to decentralize finance will remain utopian at best.
The author begins by showing why in some sense the current financial system is decentralized already what with all the multiple intermediaries involved. But his main argument is around: “the fact that these intermediary-heavy systems are continuously gaining share relative to their big privacy-first peer-to-peer competition—cash—indicates that there is some value being provided by intermediaries.”
He then goes onto different use cases and highlights the pitfalls of automating them (which DeFi proposes):
“The first problem you’ll run into with a decentralized protocol is that it needs some kind of “oracle” to measure the value of collateral. If a decentralized protocol makes loans to small businesses, or to people buying houses, the likely borrower is someone who got rejected by a more conventional lender. Underwriting a business means trying to understand how it works, a process for which there are few standardized rules. Lending against real estate entails knowing something about the value of that real estate, and since real estate borrowers are often quite levered, the margin for error is small. But there is one category of lending where the oracle problem is easily solved: making margin loans against some product with a frequently quoted price and reasonable trading volume. In the margin lending case, the value of the collateral can be measured based on the current market price, and the risk of that collateral getting impaired can be estimated by looking at the volatility of the asset.
…A margin lending algorithm can be built based on historical backtests, but what it can’t backtest is the change in market structure caused by its own existence. This is by no means unique to decentralized finance, of course. It’s a good description of what happened in 1987. Some smart academics discovered that an investor could replicate an options position using futures—as the market declines, selling more put options replicates the position that an options market-maker would have in order to hedge a put option, but in this case the market-maker doesn’t have to get paid some premium for writing the option in the first place. This strategy got popular enough that when the market did face a big decline, it set off a wave of mostly automated selling. The stock market crashed that day, with the S&P 500 down 20.5%. Futures crashed even worse, though, at one point trading at a 15% discount to the underlying stocks.3 The backtest for portfolio insurance didn’t cover a period where portfolio insurance existed, and thus underestimated both the odds of a stock market crash and the odds that futures would crash harder, ruining the hedge.”
The article also discusses the issues with automated market making and automated payments before acknowledging there could still be areas of finance that can evolve gradually towards minimal human intervention, but DeFi could remain a pipe dream.
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Note: the above material is neither investment research, nor financial advice. Marcellus does not seek payment for or business from this publication in any shape or form. Marcellus Investment Managers is regulated by the Securities and Exchange Board of India as a provider of Portfolio Management Services. Marcellus Investment Managers is also regulated in the United States as an Investment Advisor.
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