The true resilience of a system is only evident upon being subjected to severe stress; either it succumbs to the pressure or it transforms and develops. Decentralized finance (DeFi) has found its resilience tried and tested on multiple occasions, but has invariably stood the test, leading to its rapid evolution. DeFi’s emergence is perceived as a novel Darwinian experiment wherein principles of mainstream sectors like economics, governance, finance, and digital property rights are stress-tested within a new realm.
One of the most striking features distinguishing DeFi from its traditional counterpart is its approach towards credit risk. Traditionally, most financial assets, be they mortgages, futures, bonds, or even gift cards, impart some credit risks that carry associated costs. But DeFi introduces a twist to this credit risk narrative. This innovative sphere replaces credit risk with what is termed “smart contract risk”. In other words, in the world of DeFi, the consumer’s credit history doesn’t matter.
A prime example of this is AAVE, where your borrowing power is a function of your collateral value, rather than your credit history. If the collateral value plunges beyond a certain benchmark, and the smart contract operates smoothly, the position is liquidated. There is no appeal process, no failsafe.
While this might work for uncomplicated financial products, the question of treating complex, non-linear payoffs such as exotic options and structured products with a zero-credit-risk model and total transparency arises. The solution, it appears, lays in placing the full profit on-chain. Considering Ribbon Finance’s (renamed Aevo) latest venture, it successfully translates the intricate conditional payoffs of a classic financial structured product into a transparent system established via smart contracts, thereby offsetting any scope for credit risk.
These developments emphasize the role DeFi plays in embracing the unique transparency that cryptocurrencies offer. DeFi’s ability to automate intricate payoffs could be key to its potential for sustained growth. To put things into perspective, the global volume of such structured products was estimated to be around $1.5 trillion in 2021, signifying a vast area of potential for DeFi.
Despite weathering an array of setback events such as hacks, rug pulls, regulatory scrutiny, and even market slumps, DeFi shows no signs of bowing out. The larger promise of embracing DeFi hinges on treading a careful balance between disrupting traditional systems and incrementally improving financial solutions, driven by substantial global demand and adoption. To ensure the longevity of DeFi, we might have to temporarily shelf some of the grand ambitious ideals and concentrate on refining the current systems.
Source: Coindesk
