Non-custodial DeFi systems and Economic Risk
While DeFi shows tremendous hope for the formation of a new financial system that can be independent of institutional trust, many of the most popular DeFi systems that exist today still rely on the very same institutions they are aiming to replace. An example of this is using a partner bank in the traditional financial system to secure collateral assets off-chain. Centre; the brainchild of Coinbase and Circle does this by placing a US dollar into trusted bank accounts every time a USDC is minted. Moving forward, however, as these new crypto-economic systems mature, they will have to become non-custodial if they are to be independent of legacy institutions.
That said, there are many risks associated with non-custodial DeFi systems. Recently the research paper, Stablecoin 2.0, by a team of academics from Cornell and Imperial College London explored the economic risks associated with non-custodial DeFi systems.
“Non-custodial [crypto-economic systems] structurally resemble dynamic versions of risk transfer instruments, such as collateralized debt obligations (CDO) and contracts for difference (CFD).”
Note. Stablecoin 2.0: Economic Foundations and Risk Based Models, Klages-Mundt, Harz, Gudgeon, Liu, Minca
Now that participation in non-custodial DeFi systems is reaching an all-time high with the emergence of high-yield farming, it is more important than ever to assess them. The innovative investor can do this by looking at the incentive structures for its governance members, token holders, and risk absorbers respectively.
Although non-custodial systems are far riskier to their custodial counterparts, in order to replace legacy trust systems, they are necessary to develop.
For more information, the full academic paper, Stablecoin 2.0: Economic Foundations and Risk Based Models, is available via PDF
Special thanks to Jin Yon-Liiu, a Ph.D student at Cornell and one of the authors of the aforementioned paper for his insight. Thank you as well to Delphi Digital’s Medio DeMarco for his feedback.
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