Credit risks in Defi: A stablecoin-oriented perspective
0. What this article is about
This is an article about Defi credit risk which can be oriented from stablecoins. I wrote this post from an investor perspective, not a legal perspective. It has my own opinions, and I don’t represent any company or protocols.
1. Introducing Defi
Defi (Decentralized Finance) offers financial services with smart contracts like exchange(swap), lending/borrowing, flash loans, asset management, insurances, and more.
Defi has some novel identity that differs from traditional financial services, like community-driven governance (ex DAO), use of non-custodial wallets, transparent smart contracts.
As a result, Defi TVL (Total Value Locked) reached 100B USD in 2021. We can see that Defi industry is growing rapidly. Some say that Defi is the first killer app on blockchain.
2. Introducing Stablecoins
Stablecoins are cryptocurrency which is pegged into fiats. They are often used as ‘cash’ in the crypto industry. Many centralized cryptocurrency derivative/spot exchange uses stablecoins as collateral/cash. And of course, the majority of Defi protocols widely adapt stablecoins for user experience.
So, the stablecoin industry is growing fast as well as the Defi industry.
The majority of stablecoins are pegged into USD. So, we are gonna look into major USD-pegged stablecoins like USDT, USDC, DAI. We are not gonna talk about algorithmic stablecoins like UST because it has less correlation with today’s topic.
First, we look into the first type of stablecoins, the fiat-backed type. USDT (USD Tether) and USDC (USD Coin) are those. They are fiat-backed, so it means they have a fiat-based treasury that is managed by traditional custodians.
These types of stablecoins seem to have no risk at all because they really have dollars. But on the other side, it is not transparent and has credit risk because fiat accounts are off-chain and controlled by a company. In easy words, if the company’s custodian runs with the treasury money, it goes to zero.
The second type of stablecoins is the crypto-backed type. These kinds of stablecoins offer complete transparency on smart contracts. DAI is the perfect example of this kind of stablecoin. Anyone with collectrals like Ether, WBTC, Stable LP Tokens, can mint DAI on the ethereum blockchain.
As you can see, the collateral ratio varies over risks, so 1 DAI can be safely pegged into 1 dollar. If you want to withdraw your collaterals, you have to repay the same amount of DAI with a stability fee.
3. Stablecoin and Defi Credit Risk
As I said, stablecoins are crucial in Defi. They provide liquidity, offer stability, be collateral, and more. But the Defi-stablecoin structure is really risky.
First, we start from fiat-backed stablecoin like USDT and USDC. They have some transparency issues and company credit risks. But this is widely adapted into the Defi industry. These stablecoins provide liquidity and are used as collateral in loan markets, DeX swaps, Defi 2.0, and more.
Fiat-backed stablecoins are used as collaterals with other cryptos for crypto-backed stablecoins. And these crypto-backed stablecoins are even used as collectrals for other crypto-backed stablecoins, Defi 2.0, loan markets, DeX Swaps, and even for themselves.
So this collateral structure is somewhat cyclic. This means when major fiat-backed crypto breaks because of their own credit risks, like when SEC tries to regulate stablecoin companies, can break the whole Defi system.
Collateral loans based on any stablecoins will be liquidated, liquidity pools on DeXes will be drawn, crypto-backed stablecoins and Defi 2.0 coins will be going to zero. Furthermore, it can blow up the whole crypto economy’s credit.
This is not only ethereum’s problem. Other chains like klaytn, also use popular stablecoins like USDT, USDC, DAI through bridges. And they even have their own platform-native crypto-backed stablecoins like KSD(Kokoa Stable Dollar), which is backed by stablecoins from ethereum, and KLAY/KCTs. And that stablecoin does all the same what DAI does in ethereum, which leads to the same risks.
I illustrated this structure in a slide, a case study of ethereum & klaytn’s major Defi services.
4. So, How Can We Hedge This Credit Risk?
For professional & complicated hedging, you should buy insurance. Bridge Mutual protocol offers insurance for stablecoins. But this option is not liquid, expensive, and not affordable for the majority of investors.
The second option is to buy blue-chip mainnet cryptos such as Bitcoin, Ethereum, Solana, Terra, Klaytn, and more. Those mainnets have their own Defi infrastructure so we can use massive liquidity as much as stablecoins with these giant mainnet cryptos.
So, I think this stablecoin credit risk can make a subprime mortgage crisis in the crypto scene. Cyclic collateral structure, credit risks, risky investments… so many problems that begin with stablecoins. If one breaks, everything will break.
- Words for investors: you have to hedge your stablecoins.
- Words for crypto pioneers, we need a better stablecoin infrastructure.