DeFi and Credit Risk

We can truly assess the anti-fragility of something only when it either fractures under pressure or emerges stronger from adversity. Decentralized finance (DeFi) has weathered numerous challenges and emerged unbroken. Instead, it has solidified its position as a Darwinian testing ground, where both new and established concepts in finance, economics, governance, and digital property rights undergo rigorous trials in the ever-evolving landscape of the digital economy.

What sets DeFi apart from traditional finance? One of the primary distinctions lies in how (though not universally) major protocols approach the concept of credit risk.

In its most basic form, DeFi swaps trade off credit risk in exchange for smart contract risk.

Credit risk is an integral aspect of nearly every financial asset within conventional markets, a characteristic conspicuously absent in DeFi. Traditional financial instruments, ranging from mortgages and CME corn futures to German bunds and Amazon gift cards, inherently incorporate a credit component, accompanied by associated costs. In contrast, DeFi operates in a realm where one's credit history holds no relevance. Your ability to borrow within platforms like AAVE, for instance, is solely contingent upon the value of the collateral you provide. Should this collateral dip below a predefined threshold and the smart contract executes as intended, your position is promptly liquidated. Within DeFi, there exists no avenue for recourse, no entity to contact, and no opportunity to elucidate your circumstances.

On-chain structured products: Full transparency without credit risk

Setting up DeFi is relatively straightforward for simple financial products, such as overcollateralized lending. However, how can we establish a zero-credit-risk model and ensure complete transparency for more intricate financial instruments like exotic options and structured products?

The solution lies in implementing the entire payoff process on the blockchain. For instance, Ribbon Finance (now known as Aevo) has introduced a novel vault, which emulates a conventional TradFi structured product called an autocallable through a smart contract. You can find additional details in the provided link, but the essential concept is that the smart contract automatically carries out the product's conditional payoffs, akin to "if-this-then-that" statements in code, directing them to the appropriate address in a transparent manner. The most crucial aspect of this arrangement is that once the vault is established, neither Ribbon nor the investor retains the option to default, eliminating any credit risk entirely.

Source: Marex

Structured products and exotic options exemplify how DeFi can embrace the transparency and programmable nature of crypto. Automating intricate payout structures represents a meaningful use case that can propel it towards sustained growth. To provide context, the worldwide volume of structured products, such as autocallables, reached approximately $1.5 trillion in 2021, with Asian investors leading the way, as reported by Luma and Morningstar.

DeFi has weathered numerous challenges, including numerous security breaches, fraudulent schemes, devaluations, and increased regulatory scrutiny. It is poised to survive the current downturn in trading volume. However, the sector could increase its chances of widespread adoption by temporarily shelving some of its ambitious disruptive goals and instead concentrating on enhancing financial solutions that exhibit clear global demand and adoption potential.