“It is trust, more than money, that makes the world go round,” wrote Nobel Prize-winning economist Joseph Stiglitz.
In an Op-Ed titled In No One We Trust, Stiglitz argued that a “sputtering and incomplete” regulatory response to the 2008 global financial crisis had led to a sustained breakdown of trust in financial systems and governments.
This lack of trust in traditional finance provided the ideal conditions for the emergence of Bitcoin, which was created in 2009 with the central proposition of enabling transactions without a trusted third party. More recently, the rise of DeFi in 2020 coincided with the further erosion of trust in global monetary policy as Covid-19 sent central banks’ money printers into overdrive.
DeFi aims to solve the problem by eliminating the need for trust in institutions altogether. This drastic solution, however, comes with its own set of problems.
For one, it’s not even clear yet that a truly trustless replacement to the status quo is feasible.
US academic research has shown that even Bitcoin could not have established itself in its early days without trust and cooperation among a small group of altruistic founders. It’s far from clear that an entire alternative financial infrastructure can sprout from the DeFi ecosystem without some degree of trust.
Indeed, some might argue that DeFi – with a short history chequered by numerous hacks, Ponzi schemes, rug pulls and other scams – is as much in need of a regulatory fix as Stiglitz advocates for TradFi. And calls for DeFi regulation have grown louder amid the ongoing Celsius meltdown. As crypto sceptics with a penchant for pedantry enjoy pointing out, while trustless in blockchain parlance denotes the ability to operate without trusted intermediaries, the dictionary definition of the word is “not deserving of trust”.
Crypto purists argue the ecosystem is still finding its way. But this doesn’t change the fact that DeFi appears to be stalling, with the value of assets committed to the ecosystem – total value locked – down by more than two-thirds from its peak at the beginning of December 2021.
DeFi’s trust problem
There are two forces holding DeFi back which could prevent it from ever achieving meaningful scale. Both are related to trust. The first is the lack of trust among potential users in a system that has been plagued by scams. The second is the system’s lack of trust in its users, which limits its real-world utility.
DeFi in its current form serves largely to facilitate or leverage speculation and has so far failed to enable real economic activity. One of the main reasons for that is the very high collateral requirements of crypto-backed DeFi lending: the average collateral ratio of DeFi lending stands at well over 300%.
The need to over-collateralize DeFi is a function of the volatility of cryptocurrencies – as made painfully evident in the past few days – and the fact that DeFi platforms have no recourse to reliable credit ratings, legal enforcement of debt contracts, and varied sources of collateral. The cryptocurrency locked up as collateral just sits there, making DeFi a lot less capital efficient than TradFi.
The solution provided by a growing list of protocols is to bring credit ratings to DeFi, allowing borrowers to receive crypto loans with less or no collateral. However, all these protocols, including TrueFi, Teller, Masa Finance and RociFi, require borrowers to undergo some combination of onboarding including KYC and a credit review – things that might seem anathema to DeFi’s values of indiscriminate inclusion.
It’s unclear how these processes could ever make the leap to functioning without input from centralised entities. And it begs the question: what actually differentiates the worlds of TradFi and DeFi when the former increasingly incorporates blockchain and the latter needs to rely on centralised processes and infrastructure to broaden its utility?
Even the visionary scenario laid out in a paper titled “Decentralized Society: Finding Web3’s Soul” is far from free of the need for centralised entities. The paper, which was published in mid-May and counts Ethereum co-founder Vitalik Buterin among its authors, has rapidly become one of the top three most downloaded papers on the scholarly Social Science Research Network.
Its core proposal is the creation of so-called “Soulbound Tokens” – essentially non-transferrable NFTs which, for want of a less dystopian parallel, are best described as embodying an individual’s social credit score. The term is a nod to the “soulbound” items in World of Warcarft, which are those that can’t be traded with other players.
On the surface, Soulbound Tokens seem like a neat solution to bridge the inherent trust gap in Web 3.0. But not only does the idea of having a reputation score inextricably linked to one’s permanent digital identity sound like an episode of Black Mirror, it also requires inputs from the outside world, such as academic degrees, affiliations and attestations. A blockchain is only as strong as its weakest link, and that is often where it needs to interface with the outside world.
The futility of trustlessness
For now, trust is unavoidable. That may be a good thing, because trust is an acknowledged multiplier: trust begets trust, as they say. This has a neurochemical basis, as showing trust in others has been shown to release the feel-good hormone oxytocin. The higher their levels of oxytocin, the harder people will work to earn that trust and achieve collective goals.
As Stiglitz observed: “Without trust, life would be absurdly expensive; good information would be nearly unobtainable; fraud would be even more rampant than it is.” Critics might well claim that sounds an awful lot like the state of DeFi today. A technical solution might one day bridge the trust gap in DeFi without the need for external inputs. Ahead of that, trust will remain indispensable to not only making the world go round, but also scaling DeFi.