Decentralized Finance Is About to Face Its Biggest Battle Yet

After a relatively hands-off period when it comes to government intervention in blockchain space, times could be changing. 

Looking back, it is no overstatement to say that hardly any year had been so congested with major events as the year 2020. We experienced:

• Social upheaval and instability in the form of prolonged protests.
• The unprecedented shutdown of economic activity because of a global pandemic caused by COVID-19.
• A stock market crash in March followed by a record stock market rally thanks to Fed intervention that dwarfs the 2008 bailouts and subsequent Great Recession.  
• Record upward-transfer of wealth. Small businesses collectively lost $200 billion while corporate conglomerates gained $243 billion—and counting.

At the same time, the sphere of blockchain-powered finance achieved records of its own:

• Decentralized finance (DeFi) exploded from $1 billion in June to nearly $15 billion in December.
• Bitcoin (BTC) broke multi-year resistance and finally started an ongoing bull run thanks to key institutional investor adoption from PayPal Holdings Inc PYPL and Square Inc SQ to Microstrategy Incorporated MSTR and Guggenheim. 
• Stablecoins achieved record growth, surpassing the $20 billion market cap, which is to say, exceeding the combined value of the entire cryptocurrency market in 2017.

Nearly all events from the social and monetary spheres affect the blockchain realm to some extent. Increased anxiety over the future, rising unemployment, curtailed civil liberties—they all play a role in the increased willingness to depart from the traditional way of doing things. Those 22% of unbanked U.S. households would certainly benefit from another financial venue in the form of DeFi.

However, what happens when decentralized finance, understood in the broadest sense as encompassing DeFi, stablecoins, and cryptocurrencies, exerts enough financial power to threaten the legacy financial system?

After all, these are all cogs of the blockchain system, working together to create something that never existed before—a financial system outside the sphere of governments and banks.

Three Cogs Of Blockchain Finance

The pioneering cog, Bitcoin, changed the way we view money, expertly framed by Michael Saylor, the founder of Microstrategy:

“#Bitcoin is not a currency, nor is it a payment network. It is a bank in cyberspace, run by incorruptible software, offering a global, affordable, simple, & secure savings account to billions of people that don’t have the option or desire to run their own hedge fund.”

The second important cog spurred by BTC and Ethereum (ETH) is DeFi, representing the natural evolution of the blockchain-powered financial ecosystem. Although DeFi’s growth has been likened by many as another ICO-like craze, it is now clear that having the ability to loan and borrow without mediators is another fundamental shift. 

It may have started with vastly overvalued governance tokens, triple-digit APYs, and hacks. Yet none of these initial birthing pains have crippled its main appeal: creating banking products without banks.

The third important cog in this decentralized system is stablecoins, serving as an interface with DeFi. Cryptocurrency price volatility is a major factor in preventing its adoption as a daily-use currency, but it doesn’t prevent it from becoming a viable store of value.

Stablecoins, tokens pegged to fiat currencies or commodities, maintain one-to-one value against the USD, Euro, or other stable fiat currencies which can be easily exchanged on the forex market. The most popular ones are USDT and USDC in the upper billions market cap, while TUSD, BUSD, and DAI hold under a $1 billion market cap.

Moreover, some stablecoins are not backed up by fiat currency reserve but by Ethereum reserve. One of such stablecoins is DAI. It keeps its stable price by automatically executing smart contracts, called CDP (Collateralized Debt Position).

The Important Role of Stablecoins 

Although stablecoins are not critical for one to use DeFi protocols, they provide a key role in negating volatility. In turn, this gives people peace of mind when investing in the entire blockchain system, as demonstrated by the stablecoin market’s growth accompanying DeFi in 2020. In other words, stablecoins perfectly complement the DeFi ecosystem:

• Volatility-negating stablecoins increase the usage of DeFi platforms, as they provide a stable investment yield. This yield is often vastly superior to yields from traditional investments, between 8-12% and higher. With the Fed keeping interest rates near zero, this stark contrast represents a powerful generator for DeFi growth. 

• Stablecoins make up the bulk of DeFi’s core–liquidity pools. Liquidity pools drastically reduce market manipulation because they remove market-makers, found on centralized exchanges. By consisting of mainly stablecoins for token pairs, stablecoins provide superior liquidity. 

If one would pick a vector of attack to stifle the growing unbanked banking services, stablecoins represent a rich target.

Stablecoins As The Latest Target Of Government Undermining

Since the launch of Bitcoin in 2009, cryptocurrencies have inhabited the shadow of government regulation. There is hardly anything that causes more anxiety for crypto-holders than another piece of legislation. It may be tempting to dismiss such concerns by saying that blockchain cannot be regulated as it is essentially math riding the internet, but such a novelty system of finance needs time to mature unimpeded.

In the current maturity stage, the ability to sell whatever token for sovereign currency is the Achilles heel for decentralized finance. In other words, sovereign currency, controlled by the Fed, is the on/off ramp for blockchain innovation and growth.

Previously, usability has been the biggest hurdle for DeFi. In the realm of fintech, startups, and SaaS, usability is of utmost importance, with 87% of hiring managers prioritizing UX design. Some strides have been made in the DeFi space to make it more user friendly. But now, what many consider to be a larger, more immediate threat has emerged.

We can see how easily stablecoins can be undermined by a recent bill proposal, courtesy of Congresswoman Rashida Tlaib:

“Preventing cryptocurrency providers from repeating the crimes against low- and moderate-income residents of color traditional big banks have is critically important. That's why I'm proud to introduce the #STABLEAct with @RepChuyGarcia and @RepStephenLynch”.

Many believe a clear goal of the STABLEAct bill is to undermine stablecoin businesses outside the U.S., while simultaneously placing U.S.-based stablecoin providers under the auspices of the Federal Reserve. In other words, U.S.-based stablecoin issuers will be required to have a banking charter by the Fed, along with FDIC insurance, and other crippling traditional banking requirements.

The reaction to the STABLE Act bill has been overwhelmingly negative. Tyler Winklevoss of Gemini summed the proposal in his own words:

“So you propose to punish crypto companies for the sins of traditional big banks that they never committed, yet reward banks (the actual sinners) with a monopoly on the stablecoin sector. When has less competition and giving banks more power ever lead to more consumer protection?”

If the bill passes, it could very likely destabilize stablecoins, which will then stifle the necessary innovation and progress of the entire DeFi sector, suggests Jeremy Allaire, the CEO of Circle (USDC):

“1/8 The STABLE Act would represent a huge step backwards for digital currency innovation in the United States, limiting the accelerating progress of both the blockchain and fintech industry.”

This is the perennial problem with asymmetric power relations. You may be left relatively unharmed as you grow, enriching all sides with innovation, but once you grow to the point of representing a competitive system, the defenses of the entrenched system activate.

Many suggest this system resembles oligarchy far more than democracy, thanks to the Princeton study on enacted citizens’ vs elites’ preferences. Much will depend on public backlash, but this too is a game of attrition. On the other side of things, the competing elites may put up a sufficient fight to repel this latest legislative incursion.

To say the least, 2020 has been an eventful year. With regard to the future of DeFi, 2021 could be another storm.