Will Defi’s Stablecoin Dependence Prove Deadly?

The collapse of FTX raises some existential questions: Not just about that company, not just about cryptocurrencies, but of decentralized finance (DeFi) as well.

At first glance, it shouldn’t be this way. It is the centralized finance of the crypto space — the exchanges that are being rocked by last week’s FTX Chapter 11 filing — that would seem to be the most immediately threatened, upended by what seems a crisis of trust.

The list of centralized finance “casualties” or firms seems to get a bit longer, and FTX is only the latest link in a chain that includes Celsius Network and Voyager Digital, among others. In the case of the platforms, it is the intermediaries that have been called into question about how they used customer funds.

For example, in recent days there have been reports FTX’s then-CEO Sam Bankman-Fried “loaned” trading firm Alameda Research billions of dollars, taken from the FTX platform. And as recently as this week, it has come to light that the platform’s customers may be left with nothing.   Coindesk reported late this week that Gemini saw $485 million in net outflows in a 24-hour span.

DeFi, in contrast, sidesteps the trust/intermediary construct that is necessary for CeFi and uses smart contracts and protocols to let parties transact directly with one another. The decentralized apps are tied to blockchain, and one hallmark is the decentralized wallet that lets end users have direct control over their holdings.

Banking on the Stablecoins

One mainstay of DeFi has been the stablecoin — most visibility, dollar stablecoins such as USDC and USDT — that are pegged to real assets (dollars) that are supposed to provide a measure of stability, in DeFi lending and borrowing, that is not seen with bitcoin and its brethren that have no such backing.

But as noted here in recent days, there’s at least some evidence that the backing is not as steady as some observers might have hoped. And if DeFi is to exist as a “parallel banking system” that offers a new twist on traditional financial interactions such as lending and trading, then there has to be some surety of what’s underpinning it all.

But through the past several months, stablecoins have, at times, broken through the 1:1 relationship between the tokens and the dollar pegs. Stablecoins — the privately issued ones that in turn are part of parallel banking — now sport a $150 billion market cap, industry-wide.

But as those coins are backed by a basket of a broad range of short-term holdings, often commercial debt and government debt in addition to dollars, there’s opacity and some volatility in the offing.

In addition, the volatility may be exacerbated when – it’s not an if – regulation and legislation are more firmly codified. There’s been some discussion in recent weeks as to whether banks should be the trusted source of stablecoin issuance, which would bump squarely up against the very notion of parallel banking. The only surety is that things won’t look like they did before FTX’s dramatic downfall.