‘DeFi’ and ‘TradFi’ Must Work Together
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- Authors: MICHAEL CASEY
- Published: September 1, 2022
Crypto winter and the need for integration
- The cryptocurrency industry is in the throes of a crypto winter: tokens like bitcoin and Ethereum’s ether have lost three-quarters of their value while major crypto lending and investing firms have collapsed into bankruptcy.
- Traditional finance (TradFi) is also stressed: highest inflation in 40 years, a war that’s fractured the international monetary system, an energy and commodity crisis sowing famine and political unrest, and record temperatures exposing a massive shortfall in investment to fight climate change.
- Thesis: Both DeFi and TradFi need each other. DeFi must integrate some regulatory and self-regulatory practices from TradFi to attain mainstream adoption, while stewards of the global economy should explore DeFi and crypto solutions to pressing problems.
Centralization problems in energy and rationale for decentralization
- Examples of centralization vulnerabilities:
- Negotiations hinging on a sole decision by Saudi Crown Prince Mohammed bin Salman to boost oil production.
- Germany’s dependence on Russian natural gas constraining policy choices.
- The Colonial pipeline shutdown affecting 60 million people.
- 2017’s Hurricane Maria leaving 90 percent of Puerto Ricans deprived of power for months after a few transmission lines failed.
- Argument: Vulnerability to outside events (lack of “redundancy”) is a primary reason to decentralize energy systems.
- Solution focus: Renewables (solar, geothermal, wind, recycling of waste heat and energy) because they are locally sourced and can function at wide ranges of scale.
Funding shortfall for climate action and obstacles to investment
- Climate investment gap:
- The Climate Policy Initiative estimates the world invested $632 billion in addressing climate change in 2019–20.
- The same source says $4.5–$5 trillion is needed annually to achieve net zero carbon emissions by 2050.
- Two primary barriers preventing investment:
- Lack of reliable, rapidly actionable information to measure and project outcomes.
- Lack of a source of persistent, flexible user demand to make renewable energy production economically viable.
How DeFi and crypto technologies could mobilize green funding
- Tokenization and real-time data:
- Crypto technology can convert sensor-verified generation data into unique one-off tokens via provably secure sensors and blockchain-based tracking.
- Those tokens can become collateral in a DeFi environment to give lenders remote security.
- Potential liquidity and cost impacts:
- With governments and ESG-compliant companies demanding proven carbon-reducing assets, a large pool of liquidity could form around such tokens, forging deeper capital markets and driving down financing costs.
- Illustrative scenario:
- A remote Rwandan community building a DeFi-funded solar microgrid to power a new irrigation system shows potential for local development financing.
Demand smoothing via Bitcoin mining and energy economics
- The demand problem example:
- Economies of scale: a microgrid may require at least 2 megawatts of capacity but local needs may be only 500 kilowatts.
- Bitcoin mining as a flexible energy sink:
- Bitcoin mining is geography-agnostic and will operate anywhere if energy is priced low enough.
- By definition, the cheapest form of energy is renewables.
- Already, 53 percent of the Bitcoin network runs on renewable energy, according to the Cambridge Center for Alternative Finance.
- Cambridge Center’s midrange estimate: the total Bitcoin network currently consumes around 84 terawatt hours of electricity annually, about 0.38 percent of total world consumption.
- Market and technology drivers:
- Bitcoin prices have plunged; Intel’s new Blockscale application-specific integrated circuits (ASICs) are poised to create a glut of cheap chips for miners.
- Presence of low-cost energy will become the main factor in miner expansion plans.
- Policy direction:
- Regulators should avoid preventing miners from forming relationships with renewable developers.
- Sensible energy policies should remove subsidies for dirty power plants and entice Bitcoin miners to provide long-term funding commitments to renewable providers with minimum capacity thresholds for communities.
- Equity and decentralization caveat:
- Critique of centralization models: e.g., El Salvador’s government mining Bitcoin at a government-owned geothermal plant and keeping the proceeds for itself.
- Recommendation: developing economies should encourage partnerships between miners and community-based solar microgrids to spread wealth and generation capacity.
Risks, failures, and how regulation should differ for CeFi vs DeFi
- Recent failures and contagion sources:
- Three biggest sources of recent financial contagion were centralized “CeFi” services—Celsius, Voyager Digital, and Three Arrows Capital.
- Terra Luna was a de facto Ponzi scheme and was DeFi in name only.
- Real DeFi projects such as Aave and Compound have, so far, survived stress tests relatively well.
- Security risks in DeFi:
- Crypto security firm Immunefi estimates that $670 million was lost in the second quarter of 2022 from smart contract breaches and hacks.
- Regulatory prescriptions:
- Impose stricter fiduciary requirements on managers of CeFi services—treat them like brokerages or other regulated financial institutions.
- For DeFi operations, work with the industry to develop self-regulatory solutions that leverage technological strengths and decentralized structures.
- Suggested DeFi-focused measures include:
- Expanding “bug bounties” that reward developers who identify and fix incidents.
- Mandating periodic software audits.
- Conducting frequent stress tests of leverage and collateral models.
- Foundational needs:
- Achieve consensus on what constitutes a decentralized system and whether projects intending to evolve in that direction are appropriately doing so.
- All interested parties from both DeFi and TradFi must agree on frameworks and a common lexicon, then establish standards and rules.
Michael Casey, F&D Magazine, September 2022
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