The Securities and Exchange Commission or SEC chairman Gary Gensler may expand regulations on DeFi or Decentralized Finance crypto business.
Why is the SEC so anxious about DeFi and what DeFi may create a crisis for the future?
Before we answer those questions, we want to explore what is DeFi?
What is DeFi?
The simple answer is DeFi or Decentralized Finance is a peer-to-peer financial service without a third party involved that runs on Ethereum platform (or other crypto network).
What can DeFi do?
You can do anything that traditional financial services do such as lending, getting a loan, trading, saving, and buying derivatives. However, it is better than traditional financial services because services are fully automatic and anonymous.
If DeFi sounds so wonderful, why does the SEC bother?
Because DeFi may trigger the 2008 subprime mortgage crisis.
What is the subprime mortgage crisis?
It is a financial engineering method to repackage low grade debts of others in investors with high interest rates as incentives. How low grade? Someone can have a debt of leverage of a $1 million loan that only requires to pay off 3% or $30,000.
The consequences of the subprime mortgage crisis ont only created a global financial recession, it also broke the housing market which in the past century was the best store of value asset.
Since then, the housing market became unstable and inflated.
Wait a minute! It is exactly like DeFi?!
DeFi analogy of subprime mortgage
DeFi is not only risky but unpredictable. Cryptocurrencies’ valuations are already speculated. The debt created by crypto is more speculative than any possible assets.
When assets are speculated, you need large stable assets to back it up. Think about the housing market, why are houses so expensive now? Partly because its valuation became speculative (thanks to the subprime mortgage crisis) that you will need large money to support its price.
However, DeFi only requires a small amount of deposit to make a 600% APY (Annual Percentage Yield) per month! Small principle requires getting a bigger loan. You get the idea.
Risks of DeFi
There are 4 risks.
Asset risks
Product risks
Technology risks
Uncontrollable liquidated risks
1. Asset risks
Collateral with crypto is risky because assets are leveraged on speculative assets.
2. Product risks
Its yield or rewards fluctuate that highly depending on valuation of crypto at the market price.
3. Technology risks
The DeFi is at risk of hacking. Its security needs to be constantly upgraded to prevent potential hacking.
4. Uncontrollable liquidated risks
Customers may not avoid anyone who withdraws their funds in the liquidity pool to cause them to be totally liquidated. (Mark Cuban is the victim of such risk)
SEC’s concern
The SEC may worry that the expense of DeFi may create another subprime mortgage-like crisis and the government definitely does not want to print more money to buy up the cryptocurrencies in order to back its valuation.
What is the goal of DeFi?
I think the goal of DeFi is to open another door for democratizing financial services to everyone without any requirements that discriminate against certain groups. However, we should always keep our technology in check without going beyond what it needs and create a threat to the entire society. At the end of the day, people enjoy steady and safe financial returns.