DeFi: Crashing the Counterparty

An introduction to Defi’s Potential & Challenges.

Follow the dollar and it inevitably leads through centralized entities. Capitalism might have democratized our economic systems but monetary policy remains stubbornly centralized. The adverse consequences of our modern financial system are frequently referenced: lack of transparency, 1.7 billion “unbanked” adults worldwide(1), a cycle of boom and bust. Decentralized Finance, or DeFi, is often prescribed as the solution. But DeFi is not the solve-all. If we want to fully realize DeFi’s potential to fix our financial markets, we must ensure that we are diagnosing the problems correctly. If we want to realize DeFi’s potential, we must properly understand which problems it should be attempting to solve.

Today, the general argument regarding DeFi only incorporates a limited perspective, while current analysis fails in diagnosing the problems plaguing Centralized Finance (CeFi). The narrative focuses on problems that will likely be solved by CeFi itself instead of addressing those issues that are fundamental to the system and that require enabling technology. The question at the core of this debate is how financial systems, whether centralized or decentralized, manage counterparty risk — the risk that one party in a financial transaction will default. In today’s staggeringly over leveraged markets, built on and enabled by CeFi infrastructure, counterparty risk is so large that it risks the integrity of the system as a whole. Whether DeFi can address this problem of systemic risk depends largely on its trajectory. As a pioneer in the DeFi space, Eden Block has developed a unique approach to this critical and ongoing debate. Laid out in this article, we hope that our approach will serve as a springboard for further discussion.

Intro to CeFi

Within the DeFi industry, the term CeFi has been used to refer to those crypto-based projects with centralized infrastructure. However, we use CeFi rather as a broad term which refers to the overarching network emerging from the centralized financial sector. CeFi encompasses monetary policy, financial instruments, centralized markets, and banks. The problems facing CeFi are constantly scrutinized and many focus on the preventatively high-bar of entry. However, the reality is that despite popular opinion, the largest challenge facing CeFi today is not this lack of accessibility. While legitimate problems with CeFi have prevented some 1.7 billion individuals from gaining access to financial services, positive trends in CeFi signify that innovation is rapidly starting to address these problems. Even stubbornly high international remittance costs, currently estimated at 8%, are expected to drop.

In particular, rapidly expanding access to the Internet will likely be effective in addressing these concerns. Global access to smartphones has increased dramatically by 13.8 percent since 2016, primarily because of the fall in production costs and therefore prices. Coupled with the drop in internet costs spurred by advances in infrastructure efficiency, the overall number of individuals with access to the Internet has now risen to 4.48 billion. (2) (3)

These positive trends are the result of key innovations and applications which have improved access to financial services. In Africa, mobile financial services are provided by telecom companies with no requirement for a bank account. This provides financial tools to millions of unbanked people. Applications like Robinhood and Acorn in the Western world have brought feeless investing to the pockets of millions and expanded access to financial assets that, before, required costly middlemen. In terms of remittances, new companies like TransferWise are already challenging the established remittance providers. These advancements have led experts to predict a drop in the average remittance fee to 5% in the near future. (4)(5) There is little reason to doubt that these trends won’t continue to develop along these current trajectories. The reality is that provided enough competitive innovation, these CeFi problems will mostly resolve themselves. Thus, the central problem in CeFi today and the focus of this article, is the overabundance of centralization and regulatory manipulation, particularly when it is directed at managing counterparty risk.

Counterparty Risk

When it comes to counterparty risk, the inescapable truth is that reward is always offset by risk. Risk and reward are two sides of the same coin and it is crucial to not overlook the risk our financial actions incur. Our appetite for reward has grown steadily as people have come to understand the potential of leveraged trading. Modern CeFi instruments enable leveraged and margin trading (which allows for substantially more returns on limited capital) which can lead to uncontrollably over-leveraged markets. However, as profits have increased, so too has the risk of a cascade of defaults. A highly leveraged market is inherently a house of cards. Even leveraging traditionally low-risk assets such as mortgages or Forex has led to catastrophe when prices drop suddenly or when people underestimate the risk of the underlying assets. To meet the reward appetites of modern investors, the system has taken on an inordinate amount of risk.

Leveraged trading, seemingly insured by regulation and advanced financial instruments, has made the global finance markets exceptionally profitable, but also more dangerous. The lack of transparency makes it difficult to even accurately establish how over-leveraged the markets have become. Regardless, the global derivatives market is frequently estimated to be above 1.2 quadrillion dollars (11 times the global GDP). Even if this is a rough estimate, it demonstrates the level of risk that leveraged trading is creating. (6)

Centralized finance has long taken the approach of “mutualizing” risk across the system through centralization to protect against counterparty default. If one party defaults, the system can cover the losses and protect the market from a catastrophic domino effect. Our analysis demonstrates that this attempt to solve counterparty risk through centralization is flawed from the start. In response to the massive risk increase of over-leveraged markets, tactics such as the issuance of Credit Default Swaps (CDS), reliance on credit rating agencies, increased governmental regulation, and market centralization have led to even further over-leveraging as traders are removed from the direct consequences of their risk profiles. By mutualizing the risk across all the participants in the platform, the system simply defers risk to the system as a whole and encourages mass-irresponsibility. Traders are free to pursue over-leveraged positions, leading to a systemically over-leveraged market. This cycle will continue until it busts (as it did in ’08) or is disrupted.

This counterparty risk is currently offset by centralized solutions. Three centralized agencies in the United States maintain a credit score for reference by lenders. Over 80 Central Counterparties (CCPs) serve as clearinghouses to insure the global finance market against the massive, systematic counterparty risk of 1.2 quadrillion dollars. These CCPs collectively maintain billions of dollars in liquid assets in order to bail out defaulting traders, helping protect against a systematic default. (6) Further, Credit Default Swaps (CDPs) have created financial tools in order to provide insurance to lenders to protect against defaulting parties. Markets continue to rely on the credit ratings produced by the Big Three agencies (Standard & Poor’s (S&P), Moody’s, and Fitch Group).

Given this fundamental relationship between risk and reward, in a system managed by a centralized government, centralized solutions are inevitable. In order to satisfy the high demand for reward in our financial system without introducing absurd amounts of risk, governments have been forced to essentially “rig” the system. With such high potential risk present in our capital markets, governments have sought to offset these risks by eliminating free-market principles and establishing new centralized initiatives. Governments provide bailout plans and insurance to cover traders in the event of unpredictable market volatility or irresponsible trading (or both). They artificially adjust interest rates to kickstart stagnating economies.

The problem with this approach is that these centralized solutions produce a false sense of security. While mutualized risk might be good for mitigating the potential consequences of individual error, it is bad for the system’s long term sustainability. Enjoying the rewards while being shielded from the consequences inevitably breeds irresponsibility and carelessness which permeates the entire system and endangers its future. Traders take on more risk than they would without the existence of a “mutualized risk system” to absorb their losses. Why this happens is clear. The stakes are too high. Entities are too big to fail and in an over-leveraged system, individual defaults can easily domino into a systematic collapse.

Couple this overconfidence with the risks and lack of transparency inherent to centralization and you have a catastrophe waiting to happen. Centralized financial institutions lack the required transparency yet markets place the utmost trust in them. Further, with centralization comes greater potential for mismanagement and more drastic consequences. Centralized entities also serve as massive honeypots for hackers, as demonstrated by the hack of Equifax and the theft of over 147 million American’s data. (7) Lack of transparency, a history of mismanagement, and overly enthusiastic trust is never a good combination.

The future of CeFi appears to hold more of the same. Current industry initiatives always involve more centralized control and more federal regulation. Centralized systems will continue to artificially manipulate the risk constraints, perpetuating the existing problems. As an example, consider the dire consequences caused by the lack of transparency in regards to Collateralized Debt Obligations (CDOs) in 2008. (8) Mismanagement and outright fraud by rating and credit agencies gave the global economy a false sense of security. Because the system was so highly leveraged and so interconnected, when the underlying assets collapsed, the global economy collapsed along with them. Credit Default Swaps, our market’s current attempt to provide an additional financial tool to hedge against default risk, present a similar danger. The lack of transparency in the CDS market, the interdependency of CDS providers, and the false sense of security that CDSs provide lowers the risk of default for individuals but raises it for the system.

There is no reason to think this trend will change. More centralization will always be the solution offered by centralized structures. This centralization will simply be the band-aid solution to the ultimate problem. As governments continue to look at more centralization as the solve-all for an over-leveraged market, all they are doing is placing more weight on an already teetering house of cards.

What is DeFi?

The term DeFi, although coined post-Ethereum, refers to cryptocurrencies and related decentralized applications. DeFi was founded upon the first great accomplishment of blockchain technology, Bitcoin and the establishment of the first decentralized, digital, and secure, means for the exchange of value. Post-Bitcoin, Ethereum established the concept of fully automated smart contracts on a permissionless, open network, with such contracts and their resulting effects recorded on an immutable distributed ledger, i.e. a blockchain. Subsequently, DeFi efforts have been directed towards scaling the relevant infrastructure and developing decentralized applications capable of augmenting or replacing current CeFi systems.

The progress has been underwhelming. Currently, DeFi has established a potent, though volatile, means for the exchange and store of value (bitcoin, ether, and other cryptocurrencies). In addition, the most successful DeFi projects to date are decentralized lending platforms and decentralized exchanges. Resources have also been directed at establishing an effective stable coin capable of countering the volatility in the digital asset market.

There’s Still Work to be Done

The ultimate value of DeFi lies in its potential to remove systemic risk by returning risk to users: to protect the system from careless individuals without shielding those individuals from the consequences of their own actions. We believe that DeFi has the potential to solve this paramount problem of our times. However, in order to do so, it must first overcome its own current obstacles to large-scale adoption.

The reality is that layer one blockchain solutions still lack the proper infrastructure capable of supporting a global financial market. The failings of the crypto market in March highlighted vulnerabilities when network congestion and a spike in gas prices have brought the Ethereum network to its knees, yet again. The Maker network was particularly vulnerable; a lack of Dai liquidity made it impossible to maintain a stable price, decentralized liquidity pools were completely halted, and collateral dropped significantly, making way for “zero bids”, which made it possible for Maker Keepers to take advantage of this situation.

Significant improvements must be made in blockchain governance, consensus mechanisms, and throughput, all without resorting to centralization as a solve-all. The future, however, looks bright in this regard. Scalability is already increasing dramatically, and there are no hypothetically unbreachable barriers that stand in the way of this trajectory. However, the reality is that decentralized architecture will always be less efficient than centralized architecture. It is the nature of the scalability trilemma that security and decentralization will always come at the expense of efficiency. Thus, DeFi’s impact potential depends upon its ability to offer value beyond pure efficiency — a key point to which we will return.

Another important element of scalable DeFi technology is the existence of a stable decentralized asset. Financial networks require the presence of non-volatile assets which can offset risk, thereby allowing more profitable and risky assets to be traded. CeFi uses fiat (and historically gold) to provide this stability. DeFi requires a decentralized version to serve the same purpose. Currently, while there are numerous companies trying to tackle this problem, no project has proved totally successful as of yet. Note that we do not include fiat-collateralized stable coins in the DeFi category, due to their inextricable dependence on the manipulations of government-backed currencies. MakerDAO however, offers an interesting potential solution that will be explored further in this article.

For DeFi to truly see successful integration it will also require an interoperable reputation protocol. If individual responsibility is returned back to the users themselves, it will be more critical than ever to have a transferable system for establishing trust and user reliability. Reputation must be transferable to keep bad actors from simply switching platforms and performing the same dubious activities elsewhere. This also requires transparent management of digital identities to eliminate the possibility of anonymous trading. Clear and transparent reputation algorithms, the likes of which are already in the works, will underpin this system, reducing reliance on centralized credit and rating agencies.

Ultimately, regulation is one of the most interesting aspects of DeFi adoption. As DeFi matures and more use cases are tried and tested by increasing numbers of users, the image of DeFi as a destabilizing renegade technology will begin to fade and regulatory bodies will likely become more accepting of these decentralized alternatives to CeFi. However, it is also clear that regulation will not go away. For example, regulatory bodies will continue to enforce KYC/AML laws. Thus, DeFi will not see widespread success unless it is able to build that success within the regulatory boundaries.

Overcoming this obstacle requires governments and the people they represent, to understand the potential advantages of decentralization. It must be made clear that true utility tokens are not securities and there must be a clear path towards obtaining this classification. Regulatory bodies must be shown that DeFi offers a path to reducing the systemic risk in the financial industry back to a sustainable level. This will be necessary if regulation is to support the evolution of DeFi instead of serving as a constant obstacle.

To recap, the following elements are necessary for DeFi’s wide-scale adoption:

1. Scalable blockchain infrastructure as well as user-friendly tools for building and deploying decentralized applications.
2. A trustworthy and stable digital asset.
3. An interoperable reputation system.
4. A more positive relationship with regulation.

Can DeFi Fix CeFi?

Before we continue, it’s important to summarize our conclusions. These conclusions provide our working framework for analyzing the future impact of DeFi.

Our Conclusions:

• Regulation will not go away and it will continue to force DeFi compliance.
• CeFi will continue to become more efficient, accessible, and affordable.
• DeFi will become more scalable and user-friendly, but will always lag behind CeFi in terms of raw efficiency.
• Demand for robust growth will force the financial system to take on ever-increasing levels of risk.
• In the absence of extensive DeFi integration, governments will continue to propose centralization as the solution for this increase in risk.

Regarding DeFi’s potential to impact CeFi, DeFi solutions already present clear advantages.

First, the relative lack of centralized governance in DeFi supposedly prevents the ability of centralized entities to artificially manipulate markets to redistribute risk. Given full transparency, markets are more often better suited to assess risk and respond accordingly than any centralized agency. Since any potential for outside manipulation must be encoded in the decentralized platform for all to see, the market can adapt accordingly. This holds true even if the network is updating and upgrading, given the only method of updating is by way of a transparent, decentralized governance mechanism. This makes any kind of manipulation transparent and predictable, and thus, not really manipulative at all. If the network as a whole can anticipate moves or risk redistribution, it becomes incorporated accordingly into the network. DeFi systems preclude the possibility of being as artificially risk-controlled as CeFi systems, thus limiting the potential for poor management and irresponsible trading practices.

Second, DeFi infrastructure can challenge the conventional wisdom that centralized regulation is absolutely necessary to protect individuals and stave off global financial disaster. This conclusion might be true in a highly speculative and over-leveraged market, but if DeFi can limit risk in a preventative manner, it won’t need the paternalistic hand of government.

Ultimately, DeFi’s major value lies in its ability to address systematic counterparty risk. The goal is not to simply decentralize CeFi’s solutions to this problem (i.e. distributing counterparty risk away from traders, thereby perpetuating over-leveraging). If DeFi cannot protect against counterparty risk through decentralized means, it will be forced to adhere to standards set by centralized authorities. Thus, the true promise of DeFi would be lost. Rather, DeFi must satisfy the global demand for financial amplification while reducing risk through non-centralized means.

We’ve seen several budding approaches to this question within the industry — some better than others. These early-stage strategies may serve as the groundwork for a truly comprehensive solution.

Cap The Risk

The challenge of solving counterparty risk has led many applications to simply limit the potential for financial amplification. Essentially, these applications cap the reward potential. For example, many applications require loans to be covered by adequate collateral. MakerDAO has seen success at offering decentralized Collateralized Debt Positions (CDPs). MakerDAO allows users to generate DAI (a stable coin) by locking up ETH as collateral in a smart contract. Borrowers have already found innovative ways to leverage that DAI. Some have used the borrowed DAI to purchase additional ether, thus increasing their exposure to the asset. Assuming ether rises in price, they can sell some of the ether to repurchase the necessary DAI to repay the debt, having amplified their profits.

CDPs bear a striking resemblance to CDOs, a central factor in the ’08 economic collapse albeit with several key differences. First, debt positions must satisfy the collateralization requirement (currently set at 150%) which provides adequate security provided the underlying asset (ETH) doesn’t lose value too dramatically. While some borrowers might leverage their borrowed DAI to purchase more ether, the collateralization provides a safety net for trades gone bad. Even in the case of a significant drop in ether’s value, MakerDAO algorithms automatically sell collateral and close positions if the ratio of collateral drops too low.

Further, CDPs are entirely transparent as the underlying assets can be seen by all participants. MakerDAO recently introduced support for Basic Attention Token (BAT) as a suitable collateral asset for CDPs. This further reinforces the need for transparency. The ’08 financial disaster was in large part due to the obscurity in the underlying CDO assets. People could not accurately assess risk because they couldn’t accurately define what assets they were assessing. (9)

MakerDAO is still far from offering a perfect solution, yet it has addressed the counterparty risk meaningfully. Collateral and Debt auctions were crushed beneath the pressure of the recent crash in March, which shows us that underlying infrastructure still needs to improve in order to cap the risk in a holistic manner.

Preventative Risk Management

Vega, a decentralized derivatives market provider, takes a similar approach as MakerDAO. Vega employs algorithms and automated executions to assess market risk and automatically close positions when necessary. This preventative approach to risk management works by limiting the potential for over-leveraged trading.

In addition, preventive risk management reduces system dependency on regulation and central agencies. Reactive solutions tend to take the form of emergency fund pools. These pools tend to be mandated by regulation and maintained by centralized entities. Decentralized platforms reduce this dependency simply by preventing over-leveraging. If, for example, MakerDAO or Vega significantly reduced the amount of required collateral (e.g if MakerDAO reduced the ratio from 150% to 10%), they would be essentially allowing leveraged trading (10x leverage in the previous example). The instability of underlying assets would make these leveraged positions exceptionally risky. Thus, given this scenario, platforms would likely be forced to adopt certain centralized standards to mitigate this risk. (10)

Free Market Incentives

Compound works by pooling loaned assets and allowing borrowers to borrow directly from that pool. As such, Compound’s interest rates are floating — determined, not through negotiations between lender and borrower, but as a result of the total supply and demand within the platform.

Compound addresses counterparty risk through three approaches. First, by pooling total assets, Compound provides an unprecedented level of liquidity. Unless every asset is borrowed, the platform will always maintain adequate liquidity, allowing anyone to withdraw their assets at any time. This means that even if multiple parties default, there should be enough liquidity to cover the losses for other participants. Second, to protect against default risk, adequate collateral must always be maintained by borrowers. If ever a borrower’s outstanding debt exceeds the stipulated debt to collateral ratio, then Compound’s third tool comes into effect. When a borrower partially defaults, any participant on the platform can repay the defaulter’s outstanding debt in exchange for their collateral. In other words, if a party’s debt increases beyond their required collateral level, arbitrageurs can contribute the necessary amount of assets to rebalance the portfolio. In exchange, the arbitrageur receives the collateral at a discount that incentivizes this arbitrage market.

Compound’s platform addresses counterparty risk both by limiting the level of risk exposure of borrowers and by taking a proactive approach against defaults. While they do collectivize risk in some regards by pooling the total capital, the collateral requirement ensures that individuals are still responsible for the risk they incur. The clever system of arbitrageurs keeps the platform stable even in the case of mass default. Since it should always be profitable to arbitrage due to the discount, this should ensure that the total counterparty risk of the platform never grows too large. Compound demonstrates an effective solution that employs free market incentives, rather than centralized bailouts, to insure against counterparty risk. (11)

Looking Forward

Present-day CeFi regulation often confuses cause with consequence. It treats centralization and regulation as a necessary consequence of an over-leveraged system. In reality, the very opposite holds true. Centralization and regulation are the causes of an over-leveraged system rather than the resulting solutions. The comforting hand of manipulated interest rates, rating agencies, and advanced debt instruments have encouraged people to take inordinate amounts of risk. The introduction of more regulation as a response simply worsens the cycle. Couple this overconfidence in centralized entities with a total lack of transparency and the result is a pile of kindling ready to spark.

DeFi can provide a stronger foundation for this house built on sand. It will not accomplish this by introducing tools encouraging the same level of over-leveraged trading of decentralized assets. Rather, it must prevent the over-leveraging and return responsibility back to the individual by requiring adequate amounts of collateral, by using preventative algorithms to close trades and adjust collateral, and by introducing full transparency to the system.

Ultimately, DeFi should not be seen only as limiting the potential for financial amplification. Rather, if successful, it will distribute that potential across a more stable and more diverse network. Instead of the reward coming at the expense of the stability of the network, DeFi will make rewards dependent on the success and safety of the network as well as to provide new avenues to profit. If DeFi is effectively able to democratize finance, it will open the door to new asset classes, capital markets, and will allow people to generate value, not only through investing but through staking, mining, validating, and by participating in the network.

This reward potential can already be seen by the profitable interest rates offered by platforms such as MakerDAO. Lenders can generate interest (currently at 7.5%) by staking their tokens (including less volatile stable coins). This return — especially given the lower risk due to transparency, native DeFi insurance products (see Opyn and Nexus Mutual) and preventative risk management tools — rivals even government bonds in terms of risk to reward potential. Considering the historically low offering on government bonds today, the competitive edge might well rest with these assets. Disregarding the lack of a long track record, one would be hard-pressed to find a more appealing rate than those offered by decentralized lending platforms. Surely, the potential of DeFi to offer competitive financial alternatives will not go unrealized for long.

Here at Eden Block, we focus on growing those platforms that are furthering our vision of decentralized finance — networks which fulfill the financial amplification demands of today’s markets while incentivizing responsibility and long-term sustainability.

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Thanks Dermot O'Riordan for the meaningful feedback and additional research!

References

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