TgradeFinance
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TgradeFinance

Consumer protection and the impact of Decentralized Finance on financial stability.

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The decentralization of financial products and services is edging closer towards widespread adoption, and traditional finance (TradFi) natives seek to reap the benefits of decentralized finance (DeFi). As this cutting-edge technology is adopted and institutionalized, concerns keep arising from regulators pertaining to consumer protection and financial stability. Tgrade is collaborating with blockchain ecosystem developer, Advanced Blockchain, and their team to unlock the potential of this domain. Together we set out to categorize some of these concerns and draw comparisons between DeFi and TradFi. We aim to highlight what retail investors are exposed to when participating in the crypto space and how certain solutions, such as ours, could alleviate the concerns of the regulators.

For the purpose of our research, we have defined the regulator’s concerns in financial stability as those pertaining to systemic risk, though we found it beneficial to further examine and outline practices in the crypto markets that may be causing volatility and instability.

Photo by Pablò on Unsplash

DeFi markets, the good, the bad, and the ugly

In the 2 years since DeFi exploded onto the scene, it has resembled a giant sandbox and we have witnessed a huge amount of innovation. DeFi has attracted growing interest from investors around the world, and through the innovation of protocols that introduced Automated Market Makers, we have global liquidity pools that are open 24 hours a day, seven days a week.

DeFi developers have innovated in the space with lending protocols and liquidity pools, and have taken care not to cross the line into securities (aside from derivatives). There have been some issues with regulators where instruments are being marketed without the required regulatory compliance, such as the issuance of synthetic stocks such as Tesla or Apple. The issuers claimed they were democratising investing into the popular tech stocks, while regulators saw a derivative that did not have the necessary documentation, and were not advertised as investments correctly.

The darker side of the DeFi markets has been “rules-free” trading combined with pseudo-anonymous addresses. We see manipulation of trading through a number of means such as pump and dump schemes, wash trading and spoofing on order book exchanges, front running, and rug pulls. Some may shrug this off as the price to pay for decentralization, and the advantages of early DeFi’s fast-paced innovation. However, we have learned through history that if markets are perceived to be unfair and manipulated, then it becomes a barrier to their mass adoption. There have been attempts to manipulate markets since Amsterdam in the early 1600s when the first legislation was introduced to prevent short-selling, and there have been 400 years of further legislation to ensure fair and orderly markets. While there are cases of misbehaviour, the laws ensure the markets work. It would thus be naive to believe that we can ignore mature markets in the context of DeFi and proclaim that rules are unnecessary.

Exploring the activities which contribute to swings in volatility and create the perception of manipulated markets, we gain a better understanding of how these activities work and their impact and thus can learn ways to mitigate them.

Front running

Front running is illegal in TradFi and can take the form of brokers placing orders ahead of their clients, knowing that the client orders will make a securities price go up or down depending on whether they are buying or selling orders. There are also cases where brokers act on analyst ratings before they are published to the clients. There are robust regulations and reporting mechanisms to ensure that this does not happen.

There is a grey area in TradFi in regards to High-Frequency Trading (HFT), where there is a race to have the lowest latency. HFT outfits have their servers co-located at the exchanges with the fastest equipment they can buy, and they race to process the order book information quickly and place trades ahead of everyone else.

In DeFi there is no possible way to insert an order quicker than someone else, nor are there intermediaries who can profit from the knowledge of the order flow. Front running takes place at the miner or validator level, as these are the actors who process the transactions in the transaction pool and write them into blocks. The practice is known as Miner Extractable Value (MEV) and Flashbots have done some important work on identifying and analyzing MEV which they define as “a metric representing the total value that can be extracted permissionlessly from the reordering, inclusion or censoring of transactions within a block being produced on a blockchain”. Using the Flashbots explorer we can see that on the Ethereum blockchain, between January 2020 and 6th January 2022, there has been $895m extracted. The analysis shows that 75% of the extraction involved the protocols Uniswap V2, SushiSwap, Curve, and Balancer and that the majority of the extractions involved arbitrage. MEV is not unique to Proof of Work networks such as Ethereum but can also be applied to Proof of Stake networks, where validators can reorder the mempool and insert trades.

There are also rumors and stories around the use of bots in OpenSea to front-run NFT auctions, which shows it is a wider problem within the blockchain space and is not limited to DeFi.

The cost to the investors is real as they make investment decisions on the information available using the current prices and the last trades and MEV totally undermines this, especially where the investors see an arbitrage opportunity that the MEV activities exploit ahead of the investors’ orders. There could be lasting damage to the reputation of DeFi should front running/MEV continue. While the approach from Flashbots to democratise front-running, on the premise that it is not possible to stop it in fully permissionless networks, it would be premature to capitulate to a practice that is detrimental to the wider market’s interests.

Pump and Dump

Pump and Dump schemes have an illustrious history in crypto trading, and it spilled over into the TradFi markets in 2021 where we saw the Reddit group Wallstreet Bets orchestrate larger purchases of Gamestop and other “meme stocks”. Whether it was a pure pump and dump or an ideological campaign as a continuation of Occupy Wallstreet has been widely debated.

Pump and dumps are where a small group takes a position in a token and then uses social media to generate interest in a wider group. The price rises as the wider groups buy, and the dump occurs when the insiders of the group sell their positions to make a large profit at the expense of everyone else. Clearly, these orchestrated campaigns that manipulate the prices contribute to volatility and add to investor skepticism.

Rug pulls

$2.8 bn was taken from investors (in this case, victims of fraud) through “rug pulls” in 2021. While many of these scams are not related to DeFi, it remains an issue of becoming more prevalent. The biggest “rug pull” was Thodex, a Turkish exchange, where the CEO stopped trading, blocked withdrawals and left the country, taking all crypto assets on the exchange with him. The DeFi rug pulls follow a pattern of launching a new protocol (sometimes clones of existing ones), drawing in the funds from investors, and then making off with those funds in the liquidity pools. They then close all access points, such as websites and social media accounts (if they have them). Indicators of such projects include fully anonymous developers behind a project and unaudited smart contracts, which can contain backdoors which allow the theft of funds.

These remain a plausible threat as there has been a big growth in new investors entering the DeFi space who are unaware of what to look for. Rug pulls are a symptom of a fully permissionless, unregulated market and do damage to the reputation of the DeFi sector. In addition, they cause real harm to investors who may lose a significant amount of money.

Caveat emptor (buyer beware) is not good enough to make DeFi a safer place to invest. There are ideas to solve this around trust and reputation scores but these are voluntary and do nothing to prevent rug pulls. Putting the onus on the investor to thoroughly investigate a protocol, including reviewing the smart contracts, is not a long-term strategy to increase adoption.

The effects of highly automated margin call on the volatility of the market

High volatility has several causes, especially in downturns. The futures markets, which require margin, are vulnerable, especially when the margin is crypto, to a self-reinforcing “cycle of doom” where automatic liquidations create more pressure on the price. In traditional markets, we see leverage ratios of 3x. By contrast, in the crypto markets, it is possible to have a leverage of 20x and in some cases 100x. What magnifies the liquidations is when the collateral is in crypto, and there are adverse market movements as the value of the collateral collapses forcing margin calls.

There has been a trend in futures to use USD as margin to mitigate the pressure on the margin, and this has helped tame the “whipsaw” volatility we see. In DeFi there are many protocols that facilitate leverage through lending. Derivatives such as perpetual futures are fully automated, meaning that when there is downward pressure on the markets there are high levels of liquidations. As we saw with the futures markets, using correlated assets as collateral for margin risks a downward spiral, which continues to trigger automatic margin calls and, as in the futures markets, there seems to be a trend for a slowing down in the volume of liquidations in 2021.

Graph showing aggregated Bitcoin liquidations (margins)
Source Bitcoin (BTC) Liquidations

Liquidations in DeFi happen as the protocols do not do credit checks on the borrowers but rely on over-collateralization. In downward moving markets the value of the collateral drops, then the margin calls are triggered, and the liquidations are then further amplified when the borrowers use the assets as collateral in other protocols to further leverage. As a result, other positions are then liquidated reinforcing the downward spiral. It is also observed that investors close their positions early before the margin calls to avoid costs, putting further selling pressure on the markets.

Source: https://coinalyze.net/sushiswap/usd/ftx/liquidation-chart/sushi-perp_lq/

The overall size of the crypto markets and the number of daily active wallets paint a picture of how many people are actually trading. Bitcoin represents the highest market capitalization of all cryptocurrencies, and yet only 723,503 daily active wallets were seen on 7th March 2021. We would draw a contrast between the number of addresses in Bitcoin with the popular Robinhood app used by retail investors in the traditional markets, which has 22.5m users.

Number of daily active Bitcoin addresses : Source https://www.buybitcoinworldwide.com/how-many-bitcoin-users/

This suggests that there is a relatively small pool of active traders on any given day, which means larger trades can better move the market. There is a similar picture in DeFi where there are an estimated 4m unique addresses. It should be noted that it is possible that many addresses are controlled by one person, and this figure includes addresses that are abandoned or inactive, and as such over-represents the number of users. It is more likely to be around 1m users. Gas fees have played a role in pricing people out of DeFi, and this is evidenced by larger trade volumes than Binance where fees are lower. Larger trades in lower liquidity scenarios could have an impact on liquidity.

In the crypto world there is evidence for the ability of large holders, popularly referred to as whales, to move the markets. Large established corporates like KPMG are adding cryptoassets to their corporate treasury and this is not a one-off. When Microstrategy went on a buying spree, they did so with thousands of small trades, so as to avoid moving the market. It is possible to see indicators in the market that a whale is moving. This ranges from sudden movements in the market capitalization of a token to big fluctuations to larger orders being placed at key price points (although these can also signify spoofing).

DEX platform synchronization and the efficiency of arbitrageurs in this context

The value of Automated Market Makers (AMM) is that they operate at all times, have a global pool of assets, and vary from simple iterations that adjust the price according to demand, to the more sophisticated, which can use techniques like reference pricing. This is achieved without the need for market makers to maintain a price, as AMMs have introduced the concept of Liquidity Pools. Liquidity Pools pay rewards, normally in native tokens, to the depositors.

The AMMs are isolated pools and need arbitrageurs who will take advantage of price differences, to result in the synchronization of the prices across platforms. There are, however, some platforms that do account for prices on other platforms and use Oracle services to reduce opportunities for arbitrage.

The arbitration is normally done through the use of bots, which read the price data from multiple platforms and execute trades where there are opportunities for arbitrage. There is significant competition between various bots and aggregator platforms that use bots to find and trade arbitration.

Having a bot infrastructure in place can also amplify price movements when the AMMs are connected and can result in higher volatility.

Potential steps to address and alleviate regulatory concerns

The position from the regulators is that DeFi is still in its early stages and does not present a risk to overall financial stability, as consumers are a small number. They are, however, collecting information to gain a better understanding of the space.

If DeFi continues its growth and does become a significant part of the financial landscape, it may become an issue in the eyes of the regulator for both financial stability and consumer protection.

The “no rules” or caveat emptor ethos of DeFi is an issue for safeguarding investors. While lumping all activities around DeFi as risky and thus unsuitable for retail investors may be a simplistic solution, it would be a disproportionate and incorrect reaction.

DeFi is innovating fast and there are many positives such as the ability to provide liquidity and earn a yield. In the more traditional world of finance, this is a closed shop.

Many of the issues such as front-running, wash trading, pump and dumps and rug pulls are a symptom of the pseudo-anonymous addresses on a public permissionless blockchain. The ability for people to organize these activities and not be accountable for their actions is the outcome. There needs to be a balance between decentralization and accountability and not just pronouncing pseudo-anonymity illegal, or completely ignoring its negative effects.

The balance between decentralization and accountability is a key pillar of the Tgrade blockchain. The blockchain has been set up as a permissionless, public blockchain with safeguards and incentives in place to ensure decentralization as a foundation. What Tgrade introduces is a self-sovereign set of governance tools that allow organizations to be able to create Trusted Circles (whitelists). The implementation of Trusted Circles is left to the people and organizations who set them up, and controls are applied at the onboarding and compliance level which are done off-chain. The governance mechanisms cover the voting and recording of which addresses are added to a Trusted Circle, and records can be kept linking the identity to the blockchain address off-chain.

Once we have a record of members’ addresses and the links to their identity, if a member is shown to be front-running or conducting other such activities, it is possible to take actions against them (such as fining or banning the user). The information held on chain shows the activity of the transactions, and it is easy to piece together what is happening. This mitigates risks to financial stability as it brings in controls to mitigate undesired behaviour which results in either volatility or reputational damage. With a more trustworthy and regulated landscape in place, this, in turn, increases investor confidence, which then adds liquidity. As a consequence, this new liquidity also makes it harder to move and manipulate the markets.

The Trusted Circle mechanism means that a person may belong to one or many groups. The people or organizations creating them can use the structure to create groups around asset classes and protect consumers from riskier financial instruments if they are not suitable.

Taking steps to mitigate the real issues seen in the wider crypto markets will decrease the wild swings of volatility and thus increase trust in the sector. This virtuous cycle will lead to greater adoption of the crypto markets.

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The foundation of Tgrade is a robust, secure, fully decentralized platform that offers the ability for self-sovereign groups to form and interact with each other.

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Martin Worner

Martin Worner

Building Tgrade, a public blockchain with self-sovereign governance frameworks to help bridge traditional finance.

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