DeFi Crash: DeFi Can’t Hold a Candle to the Centuries-Old Trust-Based System Called Hawala

In a history of dangerous naivete, the decentralized finance frenzy of 2021 will hold its own against the surge in collateralized debt obligations of 2007. The world had to face a financial crisis to be wiser CDO, which repackaged risky mortgage bonds to make them safer than before. “CDOs are nothing but a massive Ponzi scheme,” said the villain of a fictional account of the 2008 recession. How long would it take to learn that blockchain-based lending is equally reckless?

The idea that one could bypass regulated intermediaries such as banks and earn far higher returns by lending digital assets was a major highlight of decentralized finance, or DeFi. But that was before the bloodshed, which began last month’s fall cryptocurrency Pair Terra-Luna. The appeal of converting money to TeraUSD, a stablecoin that promised 1:1 convertibility to the dollar, lies in the roughly 20% yield on TeraUSD deposits. Withdraw funds from Anchor Protocol, main DeFi The lending application on the blockchain, Coinage, as well as Luna, crushed its sister asset.

Soon after, lenders Celsius Network and Babel made the deposit. Peter Thiel-backed lending platform, BlockFi Inc., said it has “completely liquidated or hedged” a large client believed to be Singapore-based Three Arrows Capital, a troubled crypto hedge fund. BlockFi is slashing headcount by 20% as Coinbase Global Inc., the largest US-based digital asset exchange, cuts its workforce by 18%. There is no end in sight for the crypto winter. Of the $252 billion of investor funds tied up in the DeFi protocol last December, less than $75 billion is left.

Blockchain technology promises the impossible burger version of finance: lending without trust, the most important ingredient. Market participants in DeFi are anonymous. Researchers at the Bank for International Settlements recently said, “It is not possible to assess borrowers’ risk through time-tested methods – from screening banks to reliance on reputation in informal networks.” Thus, the loans for the missing trust require more collateral. But as recent events have shown, bitcoin loans with Ethereum collateral can be as combustible as the portfolios of subprime mortgage bonds backing CDOs.

Compare the fragility of DeFi with the robustness of “hawala”, a highly efficient system of transferring money from medieval times in the Middle East and the Indian subcontinent. If DeFi relies on software code to act as an alternative to courts in enforcing contracts, hawala Attempts to fill the legal void with confidence. As Mathias Schramm and Marcus Taube describe the institutional arrangement in their 2003 paper:

“(Hawala) is able to transfer large amounts of money without resorting to the formal banking system and even keeping notes without any bookkeeping. Instead, it is based on the belief of the participating parties and its social and religious embeddedness within the Islamic community.”

Modern-day regulators hate hawala because users of multinational, club-like networks can easily circumvent anti-money laundering and terrorism financing laws. Even so, the way the system operates is nearly impossible to erase or trace. Hawala intermediaries often maintain regular banking relationships separate from legitimate small business accounts.

Good or bad, hawala is a very real money-transfer product – and has been for centuries. In contrast, most DeFi is simply decentralized kabuki. The Crypto Brothers talk big about defying government controls and the tyranny of large custodial organizations, although DeFi can’t really match the success of a major alternative, in this respect. Hawala emerged to alleviate the chaos that plagued medieval merchants traveling long distances; He then learned to live out – but with – the law.

Not only this. To be a DeFi borrower, you need more crypto collateral than your intended loan. This “restricts access to credit for borrowers who are already wealth-rich,” notes the BIS report. For DeFi lending to become a serious instrument of financial inclusion, two things must happen. First, people need to be able to take out loans under their real name to establish a pattern of trustworthy behavior. Second, more real-world assets such as buildings and equipment must get digital representation on the blockchain so that the less wealthy have some initial collateral.

For all the concerns about big tech platforms benefiting from consumer data, fintech is doing a lot better than DeFi at inclusion. Online commerce platform MercadoLibre Inc. The U.S.’s machine learning-based scoring model outperforms credit bureaus reported by credit bureaus to a traditional bank on the creditworthiness of borrowers in Argentina. Ditto for Ant Group Company’s Alipay payment network in China. Fintechs have combined a wide range of information – about a broad group of potential borrowers – that traditional lenders can find out about a narrow group of people within existing banking relationships. This has had a major impact on emerging markets. A jar of Nutella sold by a mom-and-pop shop in India now tells a potential lender something valuable about its owner’s creditworthiness.

Ignoring borrower-level information — or losing it in the maze of financial engineering — doesn’t end well. Think of high-end senior CDO installments where the underlying mortgage was subprime. DeFi needs to abandon its techno-anarchist utopia and become more real and centralized. Otherwise DeFi will enter the history of lending finance as a failure where hawala has succeeded: a 21st century trustworthy technology that is being defeated by 14th century innovation that thrives while keeping trust supreme.

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