On the surface, last Thursday looked like a bad day for DeFi.
Most prominently, MakerDAO’s “keeper” system broke down, partly because collateral was being liquidated so rapidly and partly because transaction volume hampered Ethereum’s performance. The liquidation process did not work as expected, leaving a number of lenders fully liquidated (above and beyond the expected 13% penalty) and the MakerDAO needing to auction off debt to cover a ~$5M shortfall.
As this is just the latest in a series of hard blows to decentralized finance (DeFi) projects, some are wondering if the ecosystem can sufficiently defend itself.
What does this all mean? DeFi didn’t die, but it didn’t thrive either.
So is the takeaway that open source financial infrastructure isn’t ready for prime time and can’t be trusted?
DeFi is Becoming Anti Fragile
People inside the DeFi industry already knew that the ecosystem remains a work in progress. Going into such a stress test, many would have assumed that the concern with MakerDAO would be whether DAI could hold its peg, not the processing of liquidated collateral. In fact, many in the industry are worried about financial disasters much worse than a $5M shortfall of MKR as DeFi innovation continues and attack surfaces increase.
Within 24 hours, there were a number of public commitments to participate in the MKR debt auction from well capitalized sources as well as the emergence of a DAO that could manage a pool of capital that could act as a “last resort” if this were to happen again in the future. Within 72 hours, a proposal to add USDC to alleviate liquidity concerns emerged.
Perhaps the headline should be just how well DeFi held up under the kind of stress test that only comes once every few decades, as well as how quickly the ecosystem is adapting and becoming anti fragile.
This is the first time where we can compare how DeFi held up directly to the incumbent capital markets. And it’s not clear that DeFi, with all it’s obvious faults, didn’t already perform better than the status quo in key areas.
Capital Markets Infrastructure Showing Cracks With Scarce Liquidity
As Neil Irwin of the NYT puts it in his post titled “Something Weird Is Happening on Wall Street, and Not Just the Stock Sell-Off”:
It has been an unsettling week on global financial markets, and not just because the stock market has fallen sharply enough to bring a decade-plus bull market to an end.
Underneath the headline numbers were a series of movements that don’t really make sense when lined up against one another. They amount to signs — not definitive, but worrying — that something is breaking down in the workings of the financial system, even if it’s not totally clear what that is just yet.
Despite Irwin’s suggestions otherwise, it is pretty clear what the problem is.
And there were reports from trading desks that many assets that are normally liquid — easy to buy and sell — were freezing up, with securities not trading widely. This was true of the bonds issued by municipalities and major corporations but, more curiously, also of Treasury bonds, normally the bedrock of the global financial system.
People, it is fair to say, are worried about bond market liquidity.
This post via Bloomberg was more direct in calling out the problem in its title: Nightmare on Wall Street Was All About Liquidity:
As the novel coronavirus continued to spread this week to become a pandemic, financial markets went into a tailspin and rekindled concerns about their ability to function in times of crisis.
The evaporation of liquidity was evident across virtually all asset classes, but its absence was most stark in securities which normally serve as havens and see their prices increase during a turmoil. That caused strange, unsettling moves as traders watched long-established cross-market relationships disintegrate.
Untangling all of the causes of the various stresses in markets may prove to be difficult, if not impossible. Still, an overwhelming demand for U.S. dollars from corporations and investors is blamed for drying up liquidity. Many companies are being forced to tap emergency credit lines from banks to ensure they have enough cash on hand to continue operating as their revenue streams threaten to dry up.
The Technology Underpinning DeFi Is Disruptive To Problems Related To Liquidity
While other aspects of DeFi were enduring their stress test, decentralized exchanges were shining.
Thursday was a record day for both Kyber and Uniswap, and despite concerns about returns in volatile markets, ETH/DAI liquidity providers had positive returns during the height of the volatility.
Dydx had already been seeing rapid growth prior to Thursday. Even as these (and other) DEXs and protocols are starting to grow, more stablecoin innovation is coming online.
The Fed has now thrown over $2T at the liquidity problem without making much of a dent, and a number of central banks seem to have figured out that digital currency can be the solution.
As it becomes increasingly clear that the legacy capital markets infrastructure cannot support global liquidity needs, the DeFi ecosystem is bringing substantial innovation to the problems created by that exact flaw.
The Importance of Transparency
Another important bit of context is the impact of transparency that comes with open source financial markets. Most startups don’t have their bugs found in public, and no other startups have their bugs cause their beta testers to lose their money. Except in DeFi, where all the receipts are public.
(To that point, do we think this person meant to spend $80K to execute a transaction? Or was it an $80K fat-fingered mistake?)
At this point, does anyone trust what’s going on in the Repo markets?
In September 2019, the Fed made $500B available as a temporary intervention in the repo markets that was supposed to last a few weeks. It was the first time the Fed had intervened in the repo markets since the Great Depression.
Last Wednesday, six months since that intervention, the central bank’s balance sheet was still carrying that $500B. Then on Thursday they announced they would inject an additional $1.5T into the repo markets, though it didn’t do much to stop the bleeding. And yesterday another $500B in repo market intervention.
Where did that $2T come from? It was supposed to be a 1 month, $500B temporary program that is now at least $2T and counting 6 months later. That we know of.
What don’t we know about?
Who bailed out whom? And at what cost? Are we back to socializing losses and privatizing gains?
Now another $700B in stimulus? $2T here and $700B there and pretty soon we’re talking real money.
Or is the point that we don’t know what “real money” is?
We’re about to learn some valuable lessons about the value of transparency in financial markets.
More Clarity That DeFi is the Future
One of Ray Dalio’s investment principles is:
Identify the paradigm you’re in, examine if and how it is unsustainable, and visualize how the paradigm shift will transpire when that which is unsustainable stops.
We can see this playing out in real time. It’s certainly possible that the capital markets infrastructure will rebound and better weather the coming storm, but that bet wouldn’t inspire much confidence.
As the legacy infrastructure increasingly breaks down, the value of a brand new programmable capital markets infrastructure becomes more apparent.
DeFi as a technology is currently, broadly speaking, closer to alpha than beta. Yet in many ways it weathered a historic day in the financial markets as well or better than more traditional financial services and providers, which fared quite poorly. DeFi is a long way from mature, but at the current pace of innovation likely to be the better product sooner than most think.