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Is ‘Trust’ a Necessary Prerequisite to Access Market Liquidity?

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By Abhishek Singh

In September 2008, Lehman Brothers, the fourth-largest investment bank in America filed for bankruptcy, inaugurating one of the worst crises in capitalism’s history. Millions of people who unquestioningly put their trust in the banking system stared into an uncertain and unstable future. The 2008 financial crisis put forth a fundamental question to ponder over: can we trust our banks anymore? If not, then how can we reimagine finance? 

In October 2008, Satoshi Nakamoto published the Bitcoin whitepaper, opening up the possibility of a blockchain-enabled trustless economy. Ever since that moment, blockchain technology and cryptocurrencies have addressed the ‘trust question’ head-on and provided the much-needed alternative. As the technology got more innovative and sophisticated, Decentralized Finance (DeFi) emerged as a strong challenger to Centralized Finance (CeFi).

Trust Within DeFi

An important question still remains: has DeFi truly made our financial transactions trustless? Trust, philosophically speaking, is the cornerstone of human civilization. No wonder that J.M. Barrie wrote in Peter Pan, “All the world is made of faith, and trust, and pixie dust.” There are so many things we do in our everyday lives where we trust complete strangers. We trust the food on our table to be free of harmful pesticides; we trust our water source to be clean.

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

So, trust is never inconsequential when it comes to financial transactions. Rather, we choose to trust technology (smart contracts and software) instead of people (banking officials and board directors). If we probe further, the issue boils down to that of security. The common person tends to ask, where can I safely keep my assets? In other words, the question of asset security is intricately linked with the question of trust. 

The Trust-Security Conundrum

The 2008 crisis was a manifestation of putting unquestionable trust in financial intermediaries such as banks for handling our assets. The consequences of such blind trust 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 whopping $8 trillion. Quite naturally, people became skeptical of banking institutions, and the trustless blockchain economy started spreading its wings, slowly but steadily.  

Trustless DeFi protocols have robust security features to prevent any kind of fraud, data hacks and online scams. At one level, these protocols guarantee data immutability through on-chain recording of transaction data. At another level, they conduct rigorous auditing and bug bounty programs to keep their code secure and bug-free. But despite taking necessary precautions, it was difficult to keep DeFi safe from malicious actors. For example, in 2021, scammers stole a staggering $14 billion in crypto assets, a steep rise of 79% from 2020. 

Thus, we once more come back to the question, whom will I trust to handle my financial assets and transaction data. To put it curtly, everyone and no one. Both CeFi and DeFi have vulnerabilities that fraudsters can exploit to siphon off funds. If banks have a proven track record of dubious personnel behavior and compromised servers, DeFi protocols too have system vulnerabilities. In light of these events, what users need to search for is a balance between CeFi and DeFi. In other words, they need to devise ways to manage their trust between financial systems.  

The Importance Of Trust In The Financial Ecosystem

The celebrated author Ernest Hemingway wrote, “The best way to find out if you can trust somebody is to trust them.” Perhaps that is why even after the unprecedented 2008 crisis, people continue to put their trust in CeFi. They still believe that CeFi can keep their assets safe and secure, without repeating yet another financial crisis. Thus, S&P 500 companies, which constitute a major chunk of the global CeFi space, have a market cap of $37 trillion. On the other hand, the total DeFi market cap stands at $141 billion.  

While the aforementioned data suggest a huge disparity between the CeFi-DeFi market cap, there is a different side to the story. In 2021, the S&P 500 market grew by just 15% while the DeFi trading volume grew by over 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 distributing their trust between CeFi and DeFi.  

There are multiple reasons why people are trying to create a seamless bridge of capital flows between CeFi and DeFi. First, neither financial system is foolproof, both exhibiting equal vulnerability to hacks and theft of funds. Second, lack of trust is leading to diminished confidence among retail and institutional investors, who are skeptical about liquidity contribution. Thus, the only way to secure financial assets is to distribute the risk between the two financial systems.

Addressing the Trust Crisis

To address this trust crisis, emerging platforms like Comdex are providing seamless capital flows between CeFi-DeFi. 

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

About the author:

Abhishek Singh is the Co-founder and CEO of Comdex, a decentralized synthetics 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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