Is Defi Too Good To Be True?

Alan Keegan
Jul 9, 2019 · 3 min read
Photo by Ibrahim Rifath on Unsplash

I’m Alan Keegan, I’m the CSO of Tiger Trading, and I want to talk very briefly about something in DeFi.

(You can watch/listen to this article if you prefer.)

I keep seeing people tweeting about or talking to me about wanting to put their money into high interest rate deposits on DeFi platforms.

One of the problems here is that people aren’t looking at what that exposure actually is — it’s something a lot closer to maybe a high yield corporate bond or a high yield EM bond than it is to a bank deposit, so we should be pricing it somewhere closer to the range of those things than the range of a bank deposit.

When you put money in Dharma or Compound, that protocol is lending out the same money on the other side, and that’s where interest is coming from.

And, of course, there is a default risk anywhere there is a loan. To make matters more difficult, depending on what protocol you’re using, it might not be entirely clear what happens when there is a default. There’s a laid out but complex default policy on something like Compound, but for something like Dharma I have no idea what happens when there is a default. So, if I’m putting my money in it, I’m holding a completely unknown risk. I don’t know how probable a default is, and I don’t know what happens if it does default on the other side. Are losses socialized across all deposits? Is there a bailout fund within Dharma built up from the profit in the spread? Are they planning to tranche the risk in different deposits?

Basically, I don’t know if I’m going to get any of that money back in the future — so it’s reasonable that I need to be compensated with a premium for that risk. On top of that, if you’re using something like DAI for your deposits (and thinking you can collect money on my ETH by depositing it in a CDP on Maker then getting interest on your DAI on Dharma) — it looks like your only getting the spread between the DAI stability fee and the Dharma interest rate. You are holding a leveraged (expensive) exposure to the same risks. So I might be getting 1% on that spread on a good day, then if Dharma defaults I lose my deposit and simultaneously default on my CDP. Not great.

So given the unknown risk of default, the uncertainty around how default losses are distributed, and in the case of DAI the additional risk that DAI maintains it’s peg (plus the additional issue of paying the stability fee if I’m getting my DAI from a CDP) — these “high interest rate deposits” look pretty unattractive. You’re taking on three different layers of risk you need to be compensated for in order to have your money in that deposit.

So it is not this fantastical world of, “why don’t you have your money on 11% internet loan instead of in a bank?”

It’s more “why do you have your money in a bank instead of holding exposure to an unknown default risk, an unknown default policy, and an unknown currency peg risk.” But, if somebody can explain to me if I’m missing something on the default structures for Compound or for Dharma, I would happily invite that.

At the end of the day, I’m a big fan of the developing DeFi ecosystem. This is exactly the thing from crypto (and specifically from Ethereum) that I’m most excited about. But, I want anyone getting involved to have a clear understanding of the risk they’re carrying and where we are in the development of DeFi today. DeFi is a great thing, but right now it is also just the developing, nascent, first iteration of a great thing.

Tiger Trading

Tiger Trading is an OEMS that brings institutional grade…

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