Decentralized Finance (DeFi) applications, especially on Ethereum, have become very popular over the past couple of years. Although Bitcoin is a global apolitical means of saving, the main idea of DeFi is to go beyond the creation of a new underlying monetary asset, and to provide a greater degree of decentralization in other areas of finance.
BTC and DeFi Risk Profiles
While Bitcoin’s key value proposition is built on eliminating trusted third parties in the digital money realm, it is much more difficult to completely eliminate counterparty risk in other areas of the traditional financial system.
Sure, some people make fortunes by earning returns on speculative tokens discovered in the DeFi ecosystem, but with more returns comes more risk.
For anyone working in the crypto asset market, it is vital to understand that Bitcoin and DeFi are not the same thing at all when it comes to risk profiles.
- Bitcoin is a saving technology
Bitcoin is often referred to as a speculative investment, but it is actually a new type of savings technology. The key difference between saving and investing is that saving does not generate income and should not involve the potential risk of a decline in value. Savings are money received from a person’s income over a certain period of time that is not spent. This is cash that is not at risk with any investment.
A key argument in favor of Bitcoin as a savings technology is that it is deflationary, which is in stark contrast to the inflationary standard set in government fiat currencies. In other words, Bitcoin should grow in value over time, while fiat currencies tend to lose value over time.
The main reason that government-issued currencies tend to inflate is that they stimulate investment and spending in the short term, and politicians tend to think and act in the short term. In addition, it is extremely beneficial for governments to be able to create a new currency out of thin air, rather than having to collect it from the general public through taxation.
A side effect of inflationary monetary policy is that it pushes people out of their savings (to avoid devaluation), towards more speculative investments. Thanks to Bitcoin’s deflationary monetary policy, people can simply hold onto the crypto asset and let it grow in value over the long term, instead of worrying about what’s going on in the stock market, or turning that task over to a third party.
Of course, the introduction of Bitcoin’s apolitical monetary policy, which was “carved on the tablets” with the launch of the Bitcoin network in 2009, means that governments no longer operate without competition from free-market money for savings.
Yes, gold also exists, but the precious metal is ill-suited for the digital world. Since gold is a physical object in the real world, it cannot be used over the Internet without the risk of a counterparty. The failures of gold in terms of ease of use are what led to the creation of paper money in the first place.
With Bitcoin, it’s easier to become fully sovereign and protect your savings from theft and devaluation without outsourcing that care to a bank or other custodian.
- DeFi brings more returns, but with much more risk
So, we have established that the key advantage of Bitcoin is that it allows users to maintain the value of their savings without creating counterparty risk, or transferring funds to riskier investments. So, what has happened to the DeFi phenomenon to this point? Basically, you can re-imagine the very problem that Bitcoin was created to solve, including a strong dependence on inflationary stablecoins linked to the fiat currency.
Today, the DeFi space consists of a variety of applications related to financial services, such as trading, borrowing, lending, and derivatives. Although these DeFi apps are often marketed as decentralized, not all of them are reliable, and here, in fact, they are far from Bitcoin. After all, many DeFi users get high returns on their crypto assets with these apps, and this could not have happened without introducing some increased risk factor.
In the world of DeFi applications, there are an incredible number of risk factors that overlap. These applications are crudely glued together based on potentially erroneous smart contract code, trusted oracles controlled by backdoor developers, volatile underlying network tokens (e.g. ETH, BNB), centralized stablecoins with high counterparty risk, returns expressed in Ponzi-style crypto tokens with unclear utility, and other problematic building blocks.
DeFi apps are also closely related to each other, which means that a problem with one app can affect others. In fact, this is one big house of cards that can fall apart as quickly as it became popular.
DeFi is often referred to as the Lego money system, but right now it’s more like Jenga money.
Simply put, Bitcoin is intended to be the safest and most sovereign savings option the world has ever seen, while DeFi is so far in the realm of “investment” that it is more properly called pure gambling. There’s nothing wrong with gambling, but the stark contrasts between the security of Bitcoin and DeFi are almost always completely ignored, even by some of the most prominent organizations in the field.
It is worth noting that risks also exist in regulated centralized financial institutions that use Bitcoin, however, the critical difference is that users have someone to turn to for help or blame in a situation where something goes wrong. With DeFi, the user assumes all the risk and has no protection against bad investments. Over time, DeFi applications may become more reliable and decentralized, but we have clearly not achieved this yet, so many people still prefer Bitcoin as a stable financial system.
DeFi improving over time
Today’s early DeFi projects fall into the “move fast and break” category, but over time, more robust and secure applications will inevitably evolve. It is possible to create extremely low-trust DeFi applications built on the basis of Bitcoin, and the Lightning Network is the best example of such an innovation in the financial services industry. In the case of the Lightning Network, you get payments that are much faster and cheaper than transactions made on the underlying blockchain layer, without having to make big compromises in terms of trust or counterparty risk. However, the Lightning Network still comes with a small risk of smart contract complexity, though not as much as a random DeFi app.
There are also Liquid and RSK side chains that allow for more experiments. However, these networks currently rely on federations of trusted entities rather than a proof-of-work consensus algorithm, which means they are less resistant to large-scale attacks by governments or other organizations. On Liquid, low-trust borrowing and PTC-backed lending is possible via Lend Hodl Hodl, while Sovryn migrates many DeFi applications from Ethereum to RSK, which is compatible with the Ethereum Virtual Machine (EVM).
In the long term, it is expected that a programming language called Simplicity, which is considered more reliable than Ethereum’s Solidity, will be added to Liquid, and may eventually find its application in Bitcoin itself. This will provide better confidence about the underlying code supporting more complex DeFi applications.
While DeFi security can certainly be improved, investment ultimately implies risk. All developers can do is minimize the risks at the technical level, and users will still be able to make bad bets. However, lingering issues, such as the oracle issue, which is critical for many DeFi applications, may persist.
Obviously, there is nothing wrong with taking the basic idea behind Bitcoin and trying to apply it to other financial applications, but it is necessary to understand well the difference between using a Cue Ball for savings, and the risk for any kind of investment. In addition, DeFi supporters should be honest about these new risks.
There has been some growth in the combination of Bitcoin with the DeFi phenomenon, namely through Badger DAO and Sovryn, and it will be interesting to see if this combination continues between conservative bitcoin holders, and much riskier financial applications. Despite all the risks associated with DeFi today, this trend could at least lead to the decentralization of many bitcoin applications that are now completely centralized.