Decentralized Finance (DeFi) has gained a high reputation in the crypto space in recent months, and prices of DeFi coins have recorded high performance. Rush in the DeFi space has also raised some concerns as it may pose some threats to crypto-economy.
Decentralized finance endeavors to launch products that are not governed by a central authority but are fully decentralized. However, decentralized finance can result in a worst case scenario as everyone is jumping in without even understanding it.
Collateralized Debt Obligations
Some people have compared DeFi with CDOs, which are collateralized debt obligations. CDOs were distributed by banks to investors and these were tied to the American housing market. The housing market went down and the whole system based on it collapsed. According to reports, the European and the US banks lost more than $1 trillion from January 2007 to September 2009. At that time, investors also rushed towards CDOs but then got disappointed with them.
“This situation has a lot of similarities to the issues with collateralized debt obligations which were the cause of the 2007 financial crisis (complexity which hides risk),” Richard Red, Research and Strategy lead at Decred, stated while talking to a news media outlet.
Under the umbrella of DeFi, different companies such as insurers, borrowers, or lenders, are rushed in. Red explained:
“At an aggregate level, the degree to which DeFi users string different protocols and smart contracts together must also result in some systemic risk, as each smart contract relies on the inputs from other smart contracts to behave in a predictable way.”
Complexity in DeFi Space
The complexity created by the interaction of different protocols is a risky thing, which is also difficult to explain. “The complexity that results from the interactions of all these novel protocols means that it can be very difficult even for experts to know exactly what is happening, and unexpected things which are difficult to explain happen quite regularly,” Red concluded.
Some experts are comparing DeFi with ICOs from 2017-18. ICO bubble disappeared after financial regulators had designed strict policies over the issuance and distribution of coins.