The USDC Depeg Implications on DeFi: Two Paths Forward

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The USDC depeg has raised significant concerns and questions about the future of DeFi.

As the DeFi ecosystem heavily relies on USDC, it's crucial to evaluate potential solutions moving forward.

We have two paths for the DeFi community: rebranding as "on-chain finance" or embracing full decentralization.

Here’s what I mean.
Path 1: Rebranding DeFi as On-Chain Finance
DeFi relies on centralized components such as stablecoins, oracles, and Web2 infrastructure, which make it vulnerable to potential government crack down.

USDC itself was considered the safest collateral to such an extent that Compound v2 hard-pegged USDC to $1 USD.

Now we realize that trust in USDC ultimately relies on trusting TradFi banking system and the government. If the government really wanted to shut down (most of) DeFi, they could.

Currently, DeFi implies decentralization and trustlesness at every level, so even one centralized component compromises the whole protocol.

By rebranding DeFi as on-chain finance, the industry can maintain key benefits like self-custody, increased liquidity, composability, and a single source of truth (irreversable transactons) while acknowledging its centralized aspects.

Examples like FRAX show that projects can move towards on-chain finance without fully embracing decentralization.

Frax's goal is the Fed Master Account (FMA) to get to the Fed as close as possible, thus removing the risk of USDC and failing banks, making FRAX the closest thing to a risk-free dollar.

Even with some centralized components, projects like FRAX can still benefit from DeFi infrastructure.

It’s because the DeFi ecosystem can be maximally trustless environment that minimizes the need for human intervention.

Take Uniswap, for example: its code is designed to be immutable, which allows assets like FRAX to be traded on-chain without any censorship.

However, it's important to note that Uniswap's user interface remains centralized, making it susceptible to regulatory pressures.

This highlights the delicate balance that DeFi projects must strike between providing the benefits of decentralization and navigating the complexities of regulatory compliance.

Thus, ALL elements & protocols of DeFi will likely never be fully decentralized or censorship-resistant, so treating tokens like USDC as a risk asset and treating DeFi as on-chain finance can help address this confusion and moral dilemma.

Path 2: Embracing Full Decentralization
The second option is for the DeFi community to remove centralized elements and become as decentralized as Bitcoin.

This would involve replacing USDC with censorship-resistant collateral like Bitcoin (BTC) or Ethereum (ETH). Projects like Liquity's LUSD, Maker's DAI and Tornado Cash exemplify this direction.

Liquity’s LUSD
Liquity's LUSD is a prime example of a project that is embracing a more decentralized approach.

During the USDC crash, LUSD demonstrated its value as a safe-haven asset, providing stability amidst market turbulence. It’s like Swiss Frank in the current TradFi system.

However, it's crucial to recognize that even LUSD, with its decentralized nature, relies on price oracles which could be manipulated in extreme case scenarios.

This highlights the ongoing challenges and complexities that DeFi projects face in their quest for complete decentralization while ensuring security and reliability for their users.

Maker’s DAI
MakerDAO's vision for DAI is to establish it as a fully decentralized and unbiased global currency.

To achieve this, Maker intends to phase out the use of easily seizable collateral like USDC in its final form, ensuring a more resilient and secure foundation for the currency. This entails dropping the USD peg, if needed.

The recent heavy reliance on USDC within the DeFi ecosystem has served as a wake-up call, urging MakerDAO to accelerate its efforts in achieving this mission.

Tornado Cash
Tornado Cash stands as a testament to the fact that achieving full decentralization is possible, albeit at a high cost.

As a successful privacy tool, Tornado Cash obfuscates transaction data for senders and recipients and it boasts with a total value locked (TVL) of $247 million.

Unfortunately, this level of decentralization came at a high cost for the project's developer, who ended up facing jail time on money laundering charges.

The High Costs of Decentralization
The Tornado Cash case raises critical questions for the DeFi ecosystem:

• Are founders willing to take on the risks associated with full decentralization?
• Will users feel comfortable interacting with fully decentralized applications if it puts their wallets at risk of being blacklisted?

While not every DeFi dApp may be perceived as a threat by regulators, the possibility of regulatory intervention remains an ever-present concern in the industry. In fact, the recent crack down on stablecoins is pushing DeFi towards decentralization.

As the DeFi space continues to evolve, striking a balance between decentralization and compliance will be crucial for the long-term success and sustainability of these projects.

The D in the DAO
Imagine, for instance, if the US government were to demand the blacklisting of DAI.

How would Decentralized Autonomous Organizations (DAOs) like Curve, which permits permissionless factory pool creation, respond to such a requirement? What about Aave?

Faced with this dilemma, would the Curve DAO choose to block DAI at the smart contract level or take the risk of being blacklisted itself?

Navigating the intricate landscape of fully decentralized DeFi is no simple task, as projects must carefully balance their commitment to decentralization with the need to address potential regulatory challenges and maintain a sustainable ecosystem.

A Two-Way Future for DeFi
Actually, there is the third part for the DeFi ecosystem as a whole.

DeFi could potentially evolve in both directions simultaneously, much like the internet today. While most users access the internet via regulated services, privacy-seeking individuals can use the Dark Web for increased anonymity.

DeFi protocols may similarly exist with varying levels of decentralization and regulatory compliance.

For example, Uniswap interface may be censored, blocking access to specific tokens, but the community is free to create their own UI because the code is immutable and non-discriminatory.

The Future of Finance
The recent USDC crash has served as an eye-opener for the DeFi community, as the risk originated from a TradFi bank. This incident has made it abundantly clear that DeFi is not as decentralized as we once thought.
But the term "DeFi" has become deeply ingrained and is unlikely to be easily replaced.

Despite this, it is essential for DAOs to stop perpetuating the illusion of complete decentralization and start acknowledging the reality of the situation.

In essence, while we continue to use the term "DeFi," we should be mindful that it more accurately represents the concept of on-chain finance, which incorporates both decentralized and centralized elements.

By embracing this understanding, the DeFi community can work towards building a more resilient and transparent ecosystem.