De-fi The Next re-hypothecation Death Trap.
“The Times 03/Jan/2009 Chancellor on brink of second bailout for banks” .
The message above is the most famous message arguably in all of crypto. It is the message Satoshi left in the genesis block referring to the bailout of banks. Some say the bail-out prompted Satoshi Nakamoto , the mysterious founder , to prepone the launch of his creation Bitcoin.
In simple terms the 2008 crash also known as the subprime crisis prolonged period of low interest rates led to the housing bubble. This was a policy decision to prop up the U.S economy. Prior to the crash of 2008, banks would give loans to sub-prime borrowers with low credit ratings and no collateral. Clever Bankers would package this debt into mortgage backed securities and pool good borrowers with bad in order to minimize the impact of low quality borrowers in the pool. The rating agencies would give these funky instruments AAA ratings, yield chasers and traders loved this and that is why the show would continue until one day the number of home loan defaults started rising sharply. (partly due to change in monetary policy). The funky instruments created by banks were traded, used as collateral and further hypothecated of which derivatives where made and those were also further hypothecated. This was a tower of debt that came tumbling down when word got out regarding the rising number of defaults. Starting to get the picture?
You are probably wondering how is this relevant to de-fi and the current state of crypto?
The entire crypto narrative is based on freedom from banks who misuse our funds and take high risks. Crypto for the first time promised. Crypto was the solution. The 2017 bull run in crypto was fueled by ICO, but the current bull run has some parallels with the 2008 crisis, in the sense that it is also a re-hypothecation tower of epic proportions fueled by a phenomenon known as De-fi (Decentralized Finance).
Innovative Protocols such as Maker which would let you create soft pegged stable coins against Eth as Collateral. Compound was another major breakthrough as it was the first autonomous lending and borrowing protocol.
There was also major innovation in terms of radical new types of decentralized exchanges and a totally new phenomenon pioneered called AMM or Automated Market Makers. Unlike exchanges which are essentially match engines. AMM pools are liquidity pools where you can deposit your assets in a smart contract and essentially traders could swap assets within the pool.
There are a few basic AMM models which exist, the most popular is the Uniswap model which is based up the formula x*y=z also known as constant product market maker, which means the pool size is derived from multiplying the two assets. Any addition or removal of liquidity of one asset of the pool would affect the price of the other. The idea is that liquidity providers would earn part of the transaction fees in proportion to liquidity provided by them in the pool. (You can read more about the formula’s in detail. You can read a good explanation of Different types of AMM pools on the chain-link blog. https://blog.chain.link/challenges-in-defi-how-to-bring-more-capital-and-less-risk-to-automated-market-maker-dexs/)
The other AMM models used different formula’s and allowed even unbalanced pools where one asset has a higher proportion than the other. In short all these pools gave liquidity providers higher returns than other options such as staking or lending.
The game totally changed when the concept of governance tokens was introduced for Lending protocols and AMM liquidity providers. Protocols like KAAVA, COMPOUND and many others would give rewards to people who created debt positions known as CDP’s with them, in order to incentivize people to take loans. These tokens were pumped in price’s using traditional market makers and incentivizing techniques. Essentially these tokens had no intrinsic value and their market value was derived from the amount of liquidity they could manage to pull in their ecosystem.
AMM pools like Synthetix also used the process of liquidity mining through traditional market makers and market making bots to show healthy order book along with reward tokens in order to have 50X price pump. CRV and other pools started following suit and came up with all sorts of rewards for attracting liquidity. Yield chasers realized that the value they could earn through incentive tokens outweighed any interest liability their debt would incur, would be sufficient to service the intrest plus some extra yield. People would borrow against collateral on one platform, earn rewards for borrowing. Use the borrowed capital to either lend or borrow more and earn more rewards. The combination of generating the maximum yield through incentivized rewards + transactions fees is something known as yield farming. Yearn Finance a yield farming aggregator had its token price rise even faster than bitcoin.
The combination of Market Making and incentivized debt has led to some of these reward tokens prices skyrocketing. The current state of De-fi is similar to the 2008 crisis where essentially these intrinsically 0 value assets , in this tokens are the basis for creating debt positions and liquidity pools. Liquidity is continuously being shuffled from one De-fi platform to the other. In the event that there is a flash crash where collateralized debt is liquidated from various platforms like compound or maker, we could be looking at a situation worse than march. At the time of writing this article, there is news of $Sushi, A fork of Uniswap which attracted millions of dollars in liquidity due to incentives turned out to be an exit scam. The sushi token was traded on the top exchanges and is one of the rare tokens to be listed within a week of its creation on multiple major exchanges. There have already been many forks of Yearn. Finance, which have miserably failed such as Yam. Finance , hotdog etc. The token values followed the famous dead heartbeat pattern.
The castle of debt is on vulnerable base, susceptible to smart contract hacks, oracle errors and other unforeseen circumstances that could be more detrimental to crypto than ICO bubble was and would warrant further government action.
One point of view is that the governance token is the only incentive experimental projects can give people to attract liquidity with them and if the protocol succeeds having governance control is potentially very valuable and that is why some argue that this is the only possible incentive. This might be true to some extent but when the market is a frenzy this situation goes out of control and greed and temptation takes over good intentions and grand visions, leading to exit scams like sushi or plain old faulty code like Yam. People can make amazing yields and de-fi and the argument that it does give ordinary people a chance to make extra ordinary amount of wealth and also provide a level playing field but this is not an easy path and users need to thoroughly understand all the risks.
I believe Satoshi would be upset if he saw a re-hypothecation bubble taking place in the crypto ecosystem. Bitcoin was created on the basic premise that centralized institutions would not misuse public funds and people could control their own finance’s. Crypto has given a lot of freedom to people but it has still not made us free from our own greed and despite the technology the situation is looking eerily similar to 2008 sub-prime crisis.