## ‘DeFi’ and ‘TradFi’ Must Work Together

## Source details

**Canonical URL:** [‘DeFi’ and ‘TradFi’ Must Work Together](https://www.imf.org/en/publications/fandd/issues/2022/09/point-of-view-defi-tradfi-must-work-together-michael-casey)

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## Bibliographic details
- Authors: MICHAEL CASEY
- Published: September 1, 2022

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### 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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_Source: https://www.imf.org/en/publications/fandd/issues/2022/09/point-of-view-defi-tradfi-must-work-together-michael-casey_