DeFi: Constructing the Foundation of a New Microeconomy
MakerDAO is a widely-discussed project and microeconomic system in the blockchain industry that operates as a collateralized lending platform administered by Decentralized Finance (DeFi) protocol. It has a proven its ability to withstand, and even grow in, steep downward markets. The sole idea of a sustainable code-governed collateralized debt platform with impressive resiliency alludes to a major breakthrough in financial structuring.
As a relatively new concept that has come to light in the blockchain industry, DeFi forges meaningful financial products and services with the use of only open source protocol and decentralized networks. While many DeFi applications are being developed, such as Abra and Dharma, one of the most prominent protocols in the space right now is MakerDAO.
Decentralized Collateralized Loans Overview
MakerDAO reigns leader as the most widely used DeFi protocol currently with a total of approximately two million Ether locked up in Collateralized Debt Positions (CDPs). Its platform enables borrowers to collateralize Ether at a minimum of a 150% collateralization ratio and receive its proprietary USD stablecoin, Dai, in return. Where the network current stands today, borrowers would be required to pay 0.5% in dollar-denominated ‘interest’ via MKR, MakerDAO’s token. Use cases vary, but borrowers primarily use Dai to increase their leverage and purchase more Ether or other cryptocurrencies.
The collateralization ratio is the amount of collateral divided by the amount borrowed, or one divided by the leverage ratio. At a 200% collateralization ratio, putting up one Ether worth $100 in collateral would enable the borrower to withdraw $50 worth of Dai. If the price of Ether decreases to $75, the collateralization ratio would reach 150% and a margin call-type process would be exercised.
The MakerDAO system is in essence fully automated. There are no centralized parties dictating credit reputation and at the same time its 0.5% borrowing rate is highly competitive with traditional institutions. Considering MakerDAO has been able to withstand a sharp decline in Ether price, it has proven its structural soundness; however, this does not indicate it is foolproof. MakerDAO has developed a robust backup plan in the event of mass-defaults, but even still, risks still loom about its sustainability given its short track record.
Accountability in Decentralization
If Moore’s Law does come into play, a decentralized system operates with zero accountability. If the MakerDAO system collapsed, users would not be part of a bankruptcy liquidation process or have a representative to reach out to. These are sizable risks institutional investors would consider and factor into their decision-making. The blockchain industry’s strong focus on decentralization has led to extraordinary innovation and automation developments such as DeFi, but widespread adoption requires characteristics that are not typically attainable by decentralized applications such as accountability, support, compliance, and prioritization.
Coinbase obtained 20 million customers over the past two years and Binance posted a net profit of $446 million in 2018. Meanwhile, today decentralized exchanges execute less than 1% of total crypto trading volume per day. The value of accountability is strong and clearly illustrated by the adoption metrics of applications in the industry. These top-layer centralized applications fill in the gap for non-technical people which will consists of a large majority of the industry’s longer-term target market.
The Utility Value of Decentralization
Then why reason with implementing decentralization if adoption requires a centralized accountable entity? The blockchain industry is largely focused on decentralization but, in general, there is a misperception of the different types. For one, all blockchains are logically centralized in order to maintain similar protocol structures.
Second, blockchains can employ different levels of architectural decentralization (number of nodes in the network) which determine security and going concern. Achieving a 1,000 node blockchain network may be considered highly secure because at this scale, it would be difficult for adversaries to influence 51% of the network. Beyond a certain point of architectural decentralization, the marginal utility of adding nodes to a network may start to decline. For example, if Bitcoin achieves two million nodes, would the utility value of adding one more node to the network offset the negative utility of its environmental impact? The marginal value of decentralization eventually reaches a tipping point, and an obsession with a network becoming more decentralized will fundamentally impact the network and make it unsustainable longer-term.
Third, political decentralization is the most volatile form of decentralization in the industry. In some ways, political decentralization can be highly beneficial or alternatively detrimental. Policies allowing a central entity to maintain control of tokens which can be used in ways that would impact token holders or the network is a deleterious form of political centralization. On the other hand, high profile evangelist of an architecturally decentralized network can continuously enhance the network’s protocol and add a sense of longer-term direction which would boost enormous value to network effects and innovation.
The point here is that decentralization is valuable but it is not the answer to everything. Systems and applications need a sense of direction, improvement, and accountability. In harmony, centralized organizations building highly automated products on low-cost decentralized protocol could be immensely disruptive and over turn general static dispositions of economic rents.
Blockchain in Finance
Blockchain is a tool that was built optically for financial transactions. It represents an immutable ledger of trade records and smart contracts capable of recognizing identities, amounts, and statuses. Programmable representations of financial contracts offer benefits that traditional paper could have never accomplished autonomously. Compliance can be built in, which is the least exciting but likely the most impressive feature of digitized securities. Real-time capitalization tables and dynamic dividend/messaging capabilities are eloquent investor relations advantages that offer immeasurable value and costs efficiencies. Lastly, complexity in structured investments has never been more achievable. Revenue and profit sharing models could become more common, and as a result, unusual structures may crop up (e.g. tenured voting). What’s discussed here are the compositions of digital security offerings (DSOs), which reimagine financial capitalization structures utilizing blockchain infrastructure.
In contrast, DeFi provides financial products and services sustained by brilliant cryptoeconomics and game theory. DeFi holds promise as a cost-efficient lending platform incapable of capturing economic rent. The piece of the puzzle that’s missing for accomplishing DeFi mass adoption is accountability and support. My proposition is to layer on a Centralized Finance (CeFi) organization to offer a product that achieves the benefits of DeFi’s automation and cost savings while additionally providing the structure and support that customers need when dealing with sophisticated financial lending products. CeFi over DeFi can profoundly re-engineer the asset-backed loans market — a US market that consists of nearly $20 trillion in mortgages, auto loans, student loans, etcetera.
A Re-Engineered Asset-Based Loans Market
Today, a quote on every domestic loan in the US can be traced back someway or another to the Fed funds rate. It is an interest rate set by the Federal Reserve at which banks can borrow from one another overnight to meet minimal reserves. The Fed funds rate is the grassroots of all debt and equity financing, impacting valuations and time-adjusted borrowing costs. Offering a naked loan below the Fed funds rate (which is currently set at a target rate between 2.25–2.50%) is purely mismanaged opportunity costs.
In my view, the most interesting aspect of MakerDAO is the fact that its interest rate (‘stability fee’) is completely independent of the Fed funds rate. It has seeded a new borrowing rate — one that is highly competitive and sustainable due to its robust cryptoeconomic ecosystem. It is constructing the foundation to a new microeconomy. In theory, if MakerDAO was scalable to macroeconomic levels, the stability fee would standardize the time value of money.
Collateralized loans can massively benefit from this competitive rate. Interestingly, CDPs are not termed loans and do not account for credit and time-adjusted variables in its borrowing rate; therefore, they do not factor in idiosyncratic risks. From a portfolio manager’s perspective, this would be viewed as lost opportunity costs or outlandishly unsustainable.
Currently the MakerDAO system only accepts Ether for collateral, but what if assets material to the macro-economy were tokenized and could interoperate digitally such as real estate? In theory, one could collateralize these digitized assets such as a real estate deed for a loan on a DeFi system. Because MakerDAO or alternatively a separate multi-collateral equivalent is capable of sustaining a highly-competitive interest rate quote, it could revolutionize a new asset-backed loans market.
According to Freddie Mac, the average 30-year mortgage rate on a loan is 4.41%. Mortgagees (i.e. lenders) often use the mortgage rate as a sliding scale adjusting for risks. The higher the risks of the borrower (credit, income, etc.), the higher the rates. In the mid-2000’s, lenders were giving out high risk (subprime) loans at unsustainable rates and structures, such as adjustable-rate mortgages (ARMs) when lenders were forecasting rates to increase. ‘Exploding’ ARMs increased to 12% interest rates from 7%, leading to a massive eruption of increasing payments and, subsequently, defaults across high-risk borrowers. We all know how the story plays out from here.
A sliding scale of interest rates across mega-risky borrowers is clearly not a scalable or sustainable model as witnessed during the 2008–2009 great recession. CDPs, on the other hand, use a sliding scale of collateralization ratios and to this day have accomplished a zero-buyout situation, even with a collateralized asset that is significantly more volatile than home prices.
*US Home Index quarterly data from 2005 to 2018, capturing 2008 volatility
**Coinmarketcap quarterly data from 2017–2018
***Equivalent to the standard deviation/mean
Arguably, accomplishing a new borrowing rate at scale is a separate story — one that would require a meticulous reevaluation of the system. Currently, MakerDAO’s CDP system sets the minimum collateralization ratio at 150%. The average collateralization ratio on the system right now is 285%, indicating users are averaging a loan-to-value of 35%. It would be unrealistic to presume potential homeowners would be able to cough up a 65% down deposit on a real estate property. However, Ether is more volatile asset class. Using the existing financial system, mortgages are typically set at at 125% collateralization ratio (20% down deposit) but quote a significantly higher interest rate — currently around 4.5% for high credit score individuals. With Fed Funds at around 2.5% (the rate banks can borrow from other banks), traditional finance lenders are capturing the difference of 2% to keep the lights on. If a 0.5% rate CDP is pragmatic, 4% of the 4.5% rate would be considered economic rent.
My CeFi/DeFi proposition must come into play here. Leveraging this new highly-efficient grassroots interest rate system, a centralized finance organization could help borrowers refinance their mortgages at lower rates by tokenizing their real estate property deed, collateralizing the deed, and using the borrowed Dai to pay off the remainder of their traditional mortgage. The central finance organization would provide support, compliance, and accountability — the attributes non-tech savvy adopter would require in a newly functioning, yet disruptive, DeFi model. For high-risk borrowers, increasing the collateralization ratio could be an effective and sustainable way to mitigate volatility. It is understandable that this would exclude many high-risk borrowers in the mortgage search process, but they would always have a chance to refinance to a DeFi CDP when they hit their collateralization target. Because of DeFi’s de mimimus costs of operations and new grassroots interest rate system, this could cause a major shift in the financial markets — for better or for worse.
Taking interest rate control out of the Fed’s hands could be detrimental to the economy. The Fed uses the Fed funds rate to loosen (stimulate) or tighten (constrict) an economy for sustainability purposes. A perpetually low interest rate of 0.5% may overstimulate the economy, causing higher-than-normal debt levels. Ultimately this could lead to disastrous bubbles akin to (or even worse than) the great recession.
Although, what if multiple CDPs were assigned to different asset classes? Currently, the Fed funds rate encapsulates a balance of the entire economy. However, what if one asset class need to be constricted/stimulated more than others, such as mortgages during 2005–2007? How about the current state of the student loan market where low rates have caused substantial inflation across higher education? The economy balanced by one interest rate is subject to chaos theory, but fragmenting asset class borrowing rates could decentralize economic stability. On second thought, this would be difficult to achieve because interest rate swaps would provide arbitrage opportunities that bring the system to a balance.
Union Square Ventures’ proposition of Fat Protocols was a thought experiment about the value capture of Web 3.0, but adoption metrics to-date reflect significant value still captured at the application layer. New decentralized protocol should shift value, but perhaps it’s more of a balance than a contrast. Centralized applications that built on top of decentralized protocol add elements of value unattainable by pure decentralized models. A shift in value captured will eventually reach an equilibrium when blockchain entrepreneurs realize the value of accountability and support.
The cleverness of DeFi applications, including MakerDAO, Abra, and Dharma, could considerably benefit from another centralized layer that would enable mass adoption. Blockchain is well poised to disrupt financial infrastructure, whether its new efficiencies from digital security offerings or a reconstruction of a collateralized lending markets.
While blockchain infrastructure gets built out, it’s paramount to embrace interoperability and composability on the application layer. With these characteristic, CeFi over DeFi could offer promising and highly-disruptive financial products and services that would achieve the first ever paradigm shift in the way macroeconomic systems operate.
Disclosure: I am not invested in MKR, but I do hold ETH. The content provided herein should not be considered investment advice, and is not a recommendation of, or an offer to sell or solicitation of an offer to buy, any particular security, strategy, or investment product. I have not received and will not be receiving any compensation as a result of this report.