Is DeFi Too Reliant on Banks?

Dear Bankless Nation,

Another day, another bank in crisis mode.

While TradFi suffers through a deeply challenging week, DeFi hasn't been fully insulated. Today, we take a look at how DeFi remains vulnerable to TradFi failures.

- Bankless team

“Going bankless” is an aspiration.

While many DeFi protocols hold their treasuries on-chain in native tokens, crypto monies, and stables -- their fill-in-the-blank “Labs” core teams take inspiration from traditional startups and turn to traditional banking solutions.

Running payroll and managing expenses from the comfort of the trad banking system is certainly less cumbersome than doing so partially or entirely on-chain. However, recent events have illuminated the fragility of fractionalized banking.

The rapid realization of insolvency at Silicon Valley Bank (SVB) and Signature, two banks declared “unsafe” by regulators and taken into FDIC receivership, provides a warning to the crypto startup community. Hopefully the message was received!

Today, we’re discussing the dependency of protocol success on trad-banked core teams, concentration risks of (crypto) startup banks, and the on-chain crypto native solutions to the problems they face.

Protocol Dependence

Behind many successful protocols are centralized groups of developers providing front-end access to on-chain smart contracts and building out future roadmap items.

Uniswap has Uniswap Labs. GMX has GMX Labs. Balancer has Balancer Labs.

Each is crucial to the success of the protocol they derive their namesake from. While decentralized token holders are often afforded governance rights to protocols and may be able to adjust certain smart contract risk parameters, they are generally not building the protocols themselves or providing easy access to the on-chain backend, placing tremendous faith in and reliance on the “Labs” side of the equation.

Success of the two unique entities is intertwined, with core teams receiving token allocations in exchange for the tremendous value they provide to the protocol. Like traditional startups, crypto’s “Labs” corporations rely on the traditional banking system. While it is extremely likely that the majority of such firms were banking with crypto-friendly banks (SVB alone boasted business relationships with half of US startups), very few publicly disclosed any business with Signature, Silvergate or SVB. Hmm.

As a significant outlier, PROOF Collective -- a members-only community behind multiple successful NFT projects, including Moonbirds, Oddities, Grails, and Emotes -- provided more transparency than most into its SVB exposure via an early tweet thread.

With some of the team’s USD deposits trapped at SVB, it is clear that the failure of the FDIC to insure all depositors would have been detrimental to PROOF’s runway. Thankfully for Kevin Rose and the rest of the PROOF community, the FDIC stepped in, insuring all uninsured depositors at SVB.

But PROOF's efforts towards transparent still negatively impacted the floor prices of many PROOF NFTs.

Unsurprisingly, teams behind liquid token projects did not seem to be racing to announce such banking difficulties; it's highly likely that project tokens would have nuked as access to front-ends and completion of future roadmap items came into question.

Banking Dilemma

Banking options for crypto startups are fairly limited, and with three central options (Silvergate, SVB, and Signature) all collapsing last week, it isn't unlikely that your average protocol’s core team had significant exposure to the collapse.

Not only did these banks serve as crypto startups’ primary nexus into the traditional banking system, they also served as the banks for many early-stage companies. Again, around half of all US-based startups had exposure to SVB!

While low interest rates proved a boon for startups in late 2020 and throughout 2021, heightened interest rates cooled early-stage funding. Venture firms reduced checks amounts, meanwhile the startups banking at SVB that weren’t profitable when they were funded remained unprofitable, continuing to burn cash.

Net inflows turned to withdrawals at these startup-centric banks, stressing cash balances of these banks and forcing them to sell securities and realize losses. Additionally, high degrees of uninsured accounts at both SVB and Signature gave depositors even more reason to panic as bank run rumors engulfed CT.

Account holders rightfully feared for the future success of their business, making the risk prudent choice and pulling funds.

Compared to a more traditional bank, such as JP Morgan or Wells Fargo where depositors are not only early stage companies, but also include cash flowing corporations and income-earning individuals, the banks that collapsed had significantly heightened concentration risk.

Part of this concentration risk is due to the specialized needs of banking startups, in addition to the regulatory hurdles faced by banks choosing to bank crypto firms and other “less desirable” banking clientele, including taboo marijuana and sex-related industries. This forces startups and crypto firms to bank with boutique options, a great idea when business is good, but one that is highly exposed to the cyclicality of their depositor’s industries and faces large degrees of risk in economic downturns.

😬 Managing Risk

No one wants their project to be the poster child of why cash management is important if we see another bank run. Assuming you’re unable to get an account at a too-big-to fail JP Morgan or Wells Fargo, do not fear! There are some solutions:

Decentralized Stables

RAI and LUSD are your friends, anon. Yes! I understand that these are not as capital efficient as competitive forms of stablecoins, but in times of banking uncertainty, you pay for security.

Once considered the golden standard of stablecoins, USDC’s weekend depeg to $0.82 on centralized exchanges displays one of the fundamental flaws in the design of centralized stablecoins: trust.

Last weekend, USDC holders no longer trusted that they may be able to redeem one coin for one US dollar. With trad banking systems offline, redemptions were not able to be processed. Panic ensued with uncertainty over how much of the $3.3B trapped in SVB would be recovered. Just like the bank run on SVB, a bank run could occur on any centralized stablecoin with inadequate collateral backing.

The spillover impacted USDC-backed decentralized stablecoins, including DAI and FRAX, with USDT the favored option.

Keep in mind, anon, that USDT is a riskier alternative to US regulated centralized stablecoin options, including USDC, GUSD, and USDP. While Tether claims to have gotten rid of its commercial paper holdings in October, we have minimal insight into the reserves backing the stablecoin, other than the fact that (so far) they have been able to process redemptions.

Opting to use Ether-backed LUSD and RAI, where proof of solvency can be verified on-chain and is dependant solely on the protocol’s ability to liquidate undercollateralized positions, is a much safer alternative in today’s banking environment.

Managing Expenses

Crypto is starting to develop solutions to payroll and expense invoices!

While startups may still be forced to pay some vendors with assistance of traditional banks, their employees and crypto native partners would likely welcome the usage of innovative crypto payments systems.

One such option is LlamaPay, a payments streaming platform from the folks over at DeFi Llama. A simplistic UI allows the streaming of both salaries and payments, with additional features for token vesting and token salaries. LlamaPay is far from perfect, however it is a step in the right direction towards tackling an issue more teams should be focused on.

Management of payroll and other expenses on-chain enables the “Labs” companies crucial to the success of our favorite crypto protocols to minimize funds stored in the traditional banking system and avoid the next banking collapse.

Limit Exposure

Going completely off-chain (being bankless) is not a feasible solution for many companies, yet storing unused funds in Ether-backed, decentralized stablecoins and switching to on-chain expense payment solutions can be a step in the right direction.

Participating in the financial system entails risk, however mitigating that risk can be accomplished with foresight and by maximizing usage of crypto-native primitives.

Don’t be caught off guard by the next bank run, anon: now is the time to prepare.

🫡