In Greek mythology, Dionysius of Syracuse offers Damocles, a sycophant, the chance to enjoy the luxuries of a King for a day. The catch, however, is that he must do this with a sword hanging above his head held by a single hair of a horse’s tail. Our financial system is akin to the legend of Damocles. It feasts on the luxury of abundant central bank liquidity oblivious to the sword hanging above.
Modern monetary theory (MMT), currently embraced by global central banks, was taken to an extreme after the pandemic which caused the market crash in March of 2020. This theory is composed of a dangerous notion that governments can continue to borrow money at an unlimited rate without consequences. MMT does nothing to strengthen the system’s resilience to shocks. Instead, it intoxicates and lulls its participants into believing that there is no sword. Worse still, it encourages a complete disregard for risk management in broader society. This is slowly nudging us towards global financial collapse.
The world of centralized finance (CeFi) is like Damocles, but oblivious to risk. It is FRAGILE.
Swapping forest fires
In a forest, flammable debris naturally falls from trees. Over time, this debris accumulates, creating a fire hazard. Lightning strikes or stray sparks ignite this debris periodically, preventing it from accumulating so much that its ignition would threaten the forest’s largest trees. Central bankers, in trying to put out small fires, have allowed tinder to build up in the form of deadwood. This creates mega-fires that put the entire system at risk. In both the subprime mortgage crisis in 2008 and the coronavirus response of 2020, we came close to financial armageddon.
Attempting to stamp out short term volatility can often lead to longer term instability. By failing to allow debris to clear from the markets, we are swapping small self-regulating forest fires for large apocalyptic ones.
Hyperbolic discounting and kicking the can down the road
Any addict knows how hard it is to quit today and how easy it will be to quit in the future — tomorrow or next week or at the start of the next year. Similarly, we have no issue imagining how easy it would be to switch to healthier habits like dieting and exercise in the future. However, we don’t want to do it TODAY. This time inconsistency is ingrained within us, it is a part of our human nature. This is mathematically described by the hyperbolic discounting model.
This bias haunts us in all walks of life. It is what intuitively drives us to avoid short term pain and volatility even if such avoidance leads to catastrophic long term effects. Centralized financial institutions are plagued with the same bias when it comes to financial prudence. However, it doesn’t have to be that way. We now have the necessary tools and technology to construct better foundations of governance free from this psychological bias.
Fintech the Phoenix
If Democles is fragile, then the Phoenix is robust. The former would meet a gory death with a small accident whereas the latter would simply respawn after a fatal encounter.
One source of fragility in the financial ecosystem is the ancient infrastructure that we still use to conduct transactions. If CeFi as a whole is the fragile Democles then fintech is the robust Phoenix. Fintech is making great progress in fixing the rusty plumbing that plagues our banking systems. However, the foundation matters. Fintech may make certain aspects of finance more robust while CeFi as a whole stays fragile. Given the current state of technology, we should strive for a system that instead evolves and gets stronger with time.
The DeFi Hydra and evolution at the speed of code
Enter Decentralized Finance (DeFi), an open and transparent system where failure is abundant in the form of small forest fires. Where experimentation is encouraged and financial evolution occurs at the speed that code is executed. The system does not coddle anyone. But the open nature of this financial world is in a constant state of play between entrepreneurs, developers, exploiters and arbitrageurs. All this activity leads to an ecosystem that is not only robust, but ANTI-FRAGILE i.e. it becomes stronger with bouts of volatility. Financial apps fail, get hacked, investors lose money and yet the system gets stronger as it learns from each failure. Without the safety net of central banks and lenders of last resort, risk management and survivability are the traits etched into the fabric of DeFi. Short term stability is swapped for innovation and longevity.
Coming back to greek mythology, Hydra is the serpentine monster with many heads. For every severed head, Hydra would regrow two in its place. If CeFi is the embodiment of fragile Damocles, then DeFi is the embodiment of the anti-fragile Hydra. CeFi is oblivious to the sword hanging above its head by a thin thread of hope of infinite central bank liquidity. DeFi embraces evolution and grows stronger each time it is attacked.
Like the mighty Hydra it is named after, Hydraswap aims to carry the DeFi flag further with constant tinkering and innovation. Our vision is to contribute towards building an anti-fragile financial infrastructure for the future. In our next article, we will dive deeper into Hydraswap, please stay tuned.