The Rise and Fall of FeFi (Fake DeFi)

Author: DeFi Education

Source: substack

It's just the basic nature of business and markets that companies (even very large ones) fail. We might feel a little sad when our favorite restaurant or clothing company goes out of business. But when a company that holds thousands or millions of your assets fails, it can make you miserable for a long time.

With the failures of Voyager, Celsius, and others, we decided to coin a new term for these companies that use decentralized assets but are themselves fully centralized (and poorly managed!). These companies use DeFi in their marketing, but it’s fake. These fake DeFi or (FeFi) companies have negatively impacted the entire industry due to their sheer size.

And real DeFi didn't fail.

Why has the mature and well-established DeFi lost zero in the recent fluctuations?

Let's take a deeper look.

What is the real DeFi?

"Centralized vs. Decentralized Finance Comparison" Source

For us, DeFi is a "fully" decentralized financial application.

Smart contracts must be immutable or fully controlled by on-chain governance. Governance can adjust parameters (e.g. decide on acceptable collateral, interest rates), but should not be able to change the agreement reached between users and the protocol.

We don't think it's acceptable for a team to manage and control keys - only acceptable as a short interim step on the path to true decentralization. This corresponds to “centrally managed DeFi” in the above diagram.

In order to meet the requirements of DeFi, the settlement layer must also be sufficiently decentralized.

Layer 1 Ethereum meets this threshold, as does Lisk with decentralized validators (independent layer 1 blockchains).

The Ethereum scaling solution (layer 2 rollup) is centralized, but we expect this to change. There are potential legal issues with putting DeFi applications on a second-layer scaling solution with a centralized sequencer.

Finally, DeFi must be free software (note: "free software" refers to software that respects user freedom and community. Roughly speaking, it means that users have the freedom to run, copy, learn, change and improve software), not just is open source software. If a centralized entity controls the intellectual property of any part of the application, then it is not DeFi.

Now, we can say that real DeFi is:

free software

Deployed on a fully independent and decentralized blockchain

Either immutable or subject to minimal on-chain governance

Apps that don’t meet the above criteria could be early-stage apps that really want to be DeFi, or fake DeFi.

Simple Checklist

Ask questions about the three "C's":

centralized

control

hosting

All failed CeDeFi (FeFi) started with "deposit your crypto and (provide)".

By accepting escrow, individuals assume the management risk of their funds, often in exchange for low returns. A 9% yield sounds great until you lose 100% of your money. If it's not unmanaged, look ahead.

centralized

Any point of centralization is an Achilles' heel and a potential target for lawyers, hackers, governments, and regulators.

We recognize that projects are often partially centralized during their launch phase. Make a judgment call on whether to invest (early investing is sometimes the right thing to do), but limit risk, as anything centralized has points of failure that can be exploited. To survive, decentralized platforms are forced to be anti-fragile. This is why we believe fully decentralized applications will be in a state of maturity.

Centralization can be subtle - a single organization controls a rollup sequencer, or a majority of validators on a blockchain.

Check the documentation, and if you're still not sure, ask on social media.

control

You need to work harder on this. This is very important.

It's not good if the team can control the keys and upgrade the smart contracts.

They may decide to take over your account or even hold some of your funds hostage. In these cases, "governance" is a joke that serves as a way for the team to avoid responsibility and make the "community" a scapegoat for an unpopular decision.

Even with on-chain governance, you need a deep understanding of how decentralized token ownership is. If the team (plus investors) still controls the majority of voting tokens, then you're not much better off, because you have to trust the team. Sometimes the protocol states that certain team tokens cannot or will not vote on governance.

Even full on-chain governance should not have complete control over the protocol. This is how the flashloan attacker was able to temporarily control enough voting tokens in Beanstalk to drain everyone's funds by sending them to an external wallet. This feature should never be part of on-chain governance.

The best protocols are those with minimal governance. Tornado Cash developers are at least partially immune to interference from law enforcement, since they have no control over the protocol at all. For protocols where governance is necessary, choose a well-governed protocol with a widely distributed token supply. However, beware of tokens being borrowed to influence votes.

Cryptocurrencies vs Traditional Financial Systems

The Bank for International Settlements has produced this form, which you can use as a reference.

Source: BIS Quarterly Review, December 2021

Why is decentralization important?

Because the lawyer is coming?

Ideological reasons?

Well, yes and no.

In our view, investors are primarily concerned with capital preservation and risk-adjusted returns.

DeFi matters because during the recent crypto crash, people who took out loans through well-designed and mature DeFi protocols lost no money.

Two unique aspects of DeFi technology provide security:

1. Transparency - all blockchain transactions are public, so anyone can obtain fraud-proof data on counterparty assets and liabilities

2. Automatic execution - the defaulting party is automatically liquidated by the smart contract according to the agreed parameters

Lending activity is usually based on a public risk profile determined by the protocol (through discussions with token holders) and published in smart contracts and protocol documents.

These rules are enforced at the smart contract level - borrowers must provide valuable collateral, not just reputation-based promises of future payments. A rogue borrower cannot use the same asset as collateral for multiple loans in multiple agreements.

Liquidations are based on market incentives in a fair, predictable and transparent manner. VIP customers don't get special treatment in private. The protocol's risk management team manages loan-to-value ratios and oversees collateral quality to ensure lenders are less likely to incur losses even under extreme market conditions.

In short, technology compensates for the shortcomings of the traditional banking model. And the performance of DeFi in a huge crypto crash proves that the technology works.

CeDeFi is essentially the worst of the two models, CeFi and DeFi. It's CeFi, but without the regulatory protections, oversight, and accountability that the traditional banking system provides.

Celsius meets DeFi

As you may have heard, the popular centralized crypto “bank” Celsius recently defaulted.

However, on July 7, it repaid about $41 million in DeFi loans, for a total of $225 million between July 1 and 7.

Source: Oasis.app

Why do you do this?

If it wanted to redeem its 21,962 BTC worth $461 million, it had no other choice.

DeFi has the best liquidation priority!

Smart contracts with self-executing security interests in Celsius collateral ensure MakerDAO lenders are protected. If Celsius defaults, its collateral will be automatically liquidated to repay the loan. A prudent risk management team at MakerDAO sets parameters (governed by MKR holders) to ensure that borrowers at risk of default are liquidated in an orderly manner. It works.

Celsius' other creditors will now have to go through a lengthy process through a slow and expensive legal system and may end up recovering little of their money.

DeFi is the first (and only) system to automatically recover collateral outside the legal system, with computerized automatic monitoring and enforcement of loan covenants. An incredible achievement.

Other Celsius-related wallets reportedly repaid substantial loans to Aave, Compound, and Notional Finance between the default and July 11, the date of publication of this article.

Under a properly designed smart contract, you as the lender get your money back. In TradFi contracts, you can get ripped off (who reads the fine print anyway?)

Here are the relevant terms from the Celsius Terms of Use:

Celsius and our third-party partners may experience cyber-attacks, extreme market conditions or other operational or technical difficulties that may result in a temporary or permanent cessation of trading. Celsius will not be liable to you for any loss or damage incurred by you as a result of such cyber-attacks, operational or technical difficulties or suspension of trading, provided Celsius has taken reasonable commercial and operational measures to prevent such incidents from occurring in technical systems controlled by Celsius or take responsibility.

challenge

Storing funds in securely written smart contracts designed by mature DeFi protocols is safer than centralized solutions.

But how do you know which protocols are well designed? How to evaluate the security of smart contracts? Whether a protocol is centralized, or whether a small number of participants have excessive control over investors' funds, digging into these facts is time-consuming.

Then there is the new regulatory and legal dimension. What if the protocol you use is shut down by the authorities? Is there a way to predict which protocols are likely to be targeted by law enforcement actions and which are sufficiently decentralized to be compliant?