Hello Tracer community!
I was thinking to write on something else, but feel compelled to provide something of a rebuttal to TradFi’s characterisation by Chainlink’s Harry from the ‘Future of Finance’ livestream.
I’ll provide my analysis below, but my fundamental criticism is aimed at Harry’s assertion that TradFi is inherently untrustworthy, because of its capacity to deliver financial outcomes at odds with the terms and conditions of its financial products/contracts. I think that’s a mischaracterisation: that flexibility is undoubtedly used sometimes to unfairly benefit TradFi – but it is just as likely to be used to modify contracts where strict performance leads to consumer detriment (particularly in the retail space). Yet whereas the performance of a traditional contract can be modified, much less opportunity would seem to be available where the contract is automated.
Far from avoiding flexibility, DeFi would do well to consider equipping its smart contracts with the capacity to vary conditions where its original performance leads to significant/widespread consumer detriment. Specifically, smart contract should be designed to incorporate responses to the following risks:
- When an external reference becomes redundant;
- When performance of the contract results in significant/widespread consumer detriment.
I’m all for having a productive conversation about all of this, so very much interested in what everyone thinks!
TradFi = ‘Just trust us’
Harry begins by framing the historical approach to finance as one where consumers have simply had to trust providers of financial products to honour their agreements, absent any checks or balances.
Clearly, this picture is incomplete and fails to take into account the success societies have had using regulation to compel performance of financial agreements in a manner largely consistent with societal and commercial norms. It’s an obvious point, and Harry might even had made if given the opportunity – but given the ideological resistance towards TradFi in certain pockets of the DeFi community, one that needs to be made.
The danger here is that an underappreciation of regulation within DeFi will lead it to develop smart contracts that fail to accommodate regulatory requirements, perhaps borne out of a position that adequate risk-management mechanisms can simply be built into the contract itself.
Yet regulatory compliance increasingly means subjecting financial contracts to ex-post regulatory modification, especially in the retail space. Financial products that are completely impervious to regulatory monitoring and intervention are increasingly at risk of being locked out of the market altogether (as Australia’s ‘contracts for difference’ industry has found out).
Harry then makes a passing reference to insurers failing to pay out claims, as part of a range of examples of TradFi failing its customers.
Insurers refuse to pay out policies for a range of reasons, including out of self-interest. A significant number of insurance disputes however stem from the terms of the insurance policy themselves becoming redundant.
Take for example insurance policies intended to cover unforeseen business interruptions: for the last year and a bit, businesses affected by lockdowns were unable to have their claims paid out, because the policies relied on a definition of a pandemic found in a law that no longer existed.
Now, a good part of that can be put down to insurers dragging this through the courts to avoid a tsunami of COVID-inspired claims, but it’s not clear to me that smart contract insurance policies would have fared any better: if anything, smart contracts would be even more susceptible to having their performance frustrated, if developers failed to update terms to external references (very happy to be educated on this point). Even the fact that these claims were litigated through the courts strikes me to be just as much as a strength of traditional contracts, as compared to their smart counterparts: at least the court has the means to change the outcome of a traditional contract.
Finally, Harry’s presentation uses Robinhood’s suspension of Gamestop share trades earlier this year as an example of a contract being unilaterally varied to suit TradFi’s commercial objectives.
In fact, Gamestop largely unfolded according to the terms and conditions of it agreement: consistent with its operating rules, Robinhood’s settlement facility DTCC made a margin call for an extra $3 billion to cover the increase in risk brought on by the explosion of trades in Gamestop shares and options.
If anything, Gamestop underscores the importance of financial institutions retaining some measure of discretion to vary agreements to avoid consumer detriment. Had Robinhood been required to actually pay up the $3billion, the likelihood is that the payment would have bankrupted Robinhood and liquidated its user’s profits and shareholdings.
Similar to the insurance situation above, it’s difficult to see how a better outcome could have been achieved if Robinhood was run on a smart contract – particularly if that would have meant the margin call being paid out irrespective of its implications for Robinhood users.
My position is that widespread adoption of DeFi is predicated on its willingness to engage with TradFi and regulation (a point made by our own @SincDavidson in the last Tracer Drop, towards the end). However, it does nothing for DeFi’s credibility if it takes a strawman approach to TradFi. Ideally, DeFi would adopt the strengths of our current approach to finance, and learn/innovate on its shortcomings.