Is “trust” a necessary precondition for accessing market liquidity?

By Abhishek Singh

In September 2008, Lehman Brothers, the fourth largest investment bank in America filed for bankruptcy, ushering in one of the worst crises in the history of capitalism. Millions of people who place their trust in the banking system unconditionally face an uncertain and unstable future. The 2008 financial crisis posed a fundamental question to ponder: can we trust our banks any more? If not, how can we reinvent finance?

In October 2008, Satoshi Nakamoto released the Bitcoin White Paper, opening up the possibility of a blockchain-based trustless economy. Since then, blockchain technology and cryptocurrencies have tackled the “question of trust” head-on and provided the much-needed alternative. As technology has become more innovative and sophisticated, decentralized finance (DeFi) has become a strong competitor to centralized finance (CeFi).

Trust in DeFi

An important question remains: has DeFi really made our financial transactions trustless? Trust, philosophically speaking, is the cornerstone of human civilization. No wonder JM Barrie wrote in Peter Pan, “Everyone is made of faith, trust, and pixie dust.” There are so many things we do in our daily lives where we trust complete strangers. We believe the food on our table is free from harmful pesticides; we believe our water source is clean.

No matter where we go or what we do, we have to trust someone or something. So even when we stop trusting banks or other financial intermediaries, we shift our trust to something else. In DeFi, we trust the protocol algorithm and code to be bug-free, and we trust the project developers to not rip us off.

Thus, trust is never without consequence when it comes to financial transactions. Instead, we choose to trust technology (smart contracts and software) rather than people (bank officials and administrators). If we go deeper, the question boils down to that of security. The ordinary person tends to ask, where can I keep my assets safe? In other words, the issue of asset security is intimately linked to the issue of trust.

The trust-security conundrum

The 2008 crisis was the manifestation of an undeniable confidence in financial intermediaries such as banks for the management of our assets. The consequences of such blind faith eventually paved the way for the worst economic disaster since the Great Depression. The global market was in a dire state with short-term losses amounting to a huge 8 trillion dollars. Quite naturally, people became skeptical of banking institutions and the trustless blockchain economy started to spread its wings, slowly but surely.

Trustless DeFi protocols have robust security features to prevent all types of fraud, data hacking, and online scams. At some level, these protocols ensure data immutability through on-chain logging of transaction data. On another level, they conduct rigorous audits and bug bounty programs to keep their code secure and bug-free. But despite the necessary precautions, it was difficult to protect DeFi from malicious actors. For example, in 2021, crooks stole a staggering amount $14 billion in crypto assets, a steep 79% increase from 2020.

Thus, we once again come back to the question, who am I going to trust to manage my financial assets and transaction data. In short, everyone and no one. Both CeFi and DeFi have vulnerabilities that fraudsters can exploit to siphon off funds. While banks have a track record of questionable staff behavior and compromised servers, DeFi protocols also have system vulnerabilities. In light of these events, what users should look for is a balance between CeFi and DeFi. In other words, they need to find ways to manage their trust between financial systems.

The importance of trust in the financial ecosystem

Famous author Ernest Hemingway wrote: “The best way to know if you can trust someone is to trust them.” This is perhaps why even after the unprecedented crisis of 2008, people continue to trust CeFi. They still believe that CeFi can keep their assets safe, without repeating another financial crisis. Thus, the companies of the S&P 500, which constitute a significant part of the global CeFi space, have a market capitalization of $37 trillion. On the other hand, the total market cap of DeFi stands at $141 billion.

While the aforementioned data suggests a huge disparity between CeFi-DeFi market capitalization, there is another side to the story. In 2021, the S&P 500 market only grew by 15% while DeFi transaction volume increased by more than 500%. The steady growth trajectory is so encouraging that some analysts expect the DeFi industry to reach $800 billion in 2022. This is a clear sign that people are diversifying their assets and spreading their trust between CeFi and DeFi.

There are several reasons why people try to create a transparent capital flow bridge between CeFi and DeFi. First, neither financial system is infallible, with both having equal vulnerability to hacks and theft of funds. Second, the lack of confidence leads to a decrease in the confidence of retail and institutional investors, who are skeptical about the supply of liquidity. Thus, the only way to secure financial assets is to spread the risk between the two financial systems.

Facing the crisis of confidence

To deal with this crisis of confidence, emerging platforms like Comdex provide continuous capital flows between CeFi-DeFi.

To conclude, it is important to remember that trust does not exist in a vacuum. One cannot become a trusted or untrusted protocol simply by publicity and empty words. Trust is not necessarily bad and may even become a keyword for the future of finance. As users redistribute their trust across CeFi-DeFi ecosystems, this will ultimately lead to better risk management and better access to market liquidity.

About the Author:

Abhishek Singh is the co-founder and CEO of Comdexa decentralized synthetic protocol in Cosmos Ecosystem.

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

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