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Understanding DeFi and its Approach to Credit Risk

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Decentralized finance (DeFi) has proven to be resilient in the face of adversity, constantly evolving and testing new concepts for the digital economy. Unlike traditional finance, one of the key differences in DeFi is how credit risk is handled by major protocols (although not all).

In simple terms, DeFi replaces credit risk with smart contract risk.

To clarify, credit risk is inherent in traditional financial assets, such as mortgages, futures contracts, bonds, and gift cards. However, DeFi disregards credit records entirely. In DeFi platforms like AAVE, your borrowing capacity depends solely on the value of the collateral you provide. If the collateral’s value falls below a certain threshold and the smart contract operates as intended, your position will be liquidated. There is no recourse, no customer service to contact, and no option to negotiate your situation.

On-chain Structured Products: Credit Risk-Free Transparency

DeFi’s straightforward approach is suitable for simple financial products like overcollateralized lending. But how do we implement a credit risk-free model with full transparency for complex products like exotic options and structured products?

The answer lies in executing the full payoff on-chain. For example, Ribbon Finance (now called Aevo) has deployed a vault that replicates a traditional structured product, the autocallable, through a smart contract. More details about this can be found here. The smart contract ensures that conditional payoffs are executed transparently and correctly. Importantly, neither Ribbon nor the investor have the option to default, eliminating credit risk entirely.

Source: Marex

DeFi’s programmable money and transparent nature lend themselves well to structured products and exotic options. Automating complex payoffs showcases the potential for meaningful applications that can drive sustained growth. In fact, the global volume of structured products, including autocallables, reached an estimated $1.5 trillion in 2021, primarily driven by Asian investors, according to Luma and Morningstar.

Despite enduring numerous challenges, including hacks, rug pulls, and regulatory scrutiny, DeFi is poised to outlast the current downturn in trading volume. However, the sector could achieve wider adoption by focusing on improving financial solutions that address global demand, even if it means temporarily setting aside disruptive ideals.

The views and opinions expressed in this article are those of the author and do not necessarily reflect those of Nasdaq, Inc.

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