The sudden short lifespan of loans is a hallmark of decentralized finance (DeFi) markets, allowing volatile cryptocurrencies to be lent to each other. Traders borrowed CRV tokens against USDC, a dollar stablecoin.
If this is a conventional debt, the borrower receives a margin call if the lender becomes uncomfortable with the collateral covering it. Public blockchains allow anyone to track such situations. Arbitrageur intervention is recommended to keep the system secure. These are algorithms that raise so-called flash loans (more on that below) to liquidate vulnerable short positions. They receive their rewards from software code (smart contracts) that run lending protocols such as Aave.
While not directly related to Eisenberg’s loan, recent research by academic researchers has concluded that DeFi has systemic vulnerabilities, liquidations spawning other liquidations. Collateral prices are affected across trading venues. sickness spreads. I blame the flash loan. Being so fast and frictionless, decentralized lending is inherently bankrupt.
On the other side are practitioners who believe that teething problems are normal in an industry that has just emerged. DeFi has fallen to traditional intermediary-driven finance, or TradFi, which, despite all the progress since the advent of the 17th-century goldsmith-banker, still relies on high taxpayer-funded bailouts. It deserves a fair chance to create a cheaper alternative to replace it. Remember the subprime crisis?
In Eisenberg’s case, there is nothing remarkable about his own loss. The problem is that his Aave on the platform has $1.6 million in bad debt after the algorithm closed his position short taking advantage of his CRV up 75% on Nov. 22. It’s been a long time. At first glance, this seems to support the fragility hypothesis of Alfred Reher, an economist at the University of Calgary, and Christine A. Parlor, a professor of finance at the University of California, Berkeley. According to them, the crucial difference between DeFi and TradFi is that the former does not impose capital constraints on arbitrageurs. is there a problem? Well, maybe.
DeFi borrowing and lending is anonymous. Without credit scoring or relying on the borrower or their reputation, the loan should always be worth significantly less than the collateral, especially since both the tokens borrowed and the coins borrowed can fluctuate greatly. must be To keep the lending pool safe, algorithms scrutinize digital platforms looking for violations of lending value standards. When Eisenberg’s position crossed the system-set allowable LTV of 0.89 on Nov. 22, they focused on volatile debt and asked for a flash loan, closing part of the original debt with the proceeds. to take away the collateral and sell it, canceling their liability.
Unlike traditional finance, these four things happen in one block of validated information. Either the transaction is fully executed and all copies of the distributed ledger reflect it, or it is not reflected at all. This is why the bot does not need to bring in capital to pocket the promised liquidation incentive (he is 4.5% in the Eisenberg episode). They do not pose a credit risk to the lender who advances the money to carry out the killing. “With the existence of flash loans, expertise is more likely to be the constraint than capital,” Lehar and Parlor point out.
Capital efficiency is perfect. However, the cost of frictionless lending systems must also be considered. Therein lies the crux of the “where is his DeFi” debate. Was the bad debt left to Aave the result of an unsolvable fatal flaw, or could a design tweak prevent it?
In a paper dealing with this episode, a group of blockchain experts found a possible answer. Once the threshold was crossed, the November 22nd liquidation turned toxic. Each time the loan was forced to close, Eisenberg’s remaining positions became a little riskier compared to the available collateral. That in turn invited another bot and everything spiraled out of control. If his fixed 4.5% liquidation incentive had been dynamic, it would have been possible for the platform to avoid bad debts if it tapered off as the collateral cover thinned.
“Toxic liquidations are dangerous for protocols because they are mathematically guaranteed that users’ portfolio health will deteriorate through no fault of their own,” said Jakub Warmuz and his co-authors. . “As a general rule of thumb, sudden, irritable reactions to complex dynamic behavior lead to worse outcomes than what the reaction was intended to achieve. Unless absolutely necessary, they should be avoided.”
A fix should arrive sooner or later. Not because our next mortgage will be his DeFi. We are lucky to have the local government property register on the public blockchain. The main motivation is that if decentralized finance could make a box of wine or a Japanese yen owed by an importer an asset on the blockchain, most traditional commodity trading could be profitable. Therefore, after paying a commission to the middleman, you can raise funds cheaper than now. In November, JPMorgan his Chase made a small trade on his Aave, taking his first live position on a public blockchain. Everything is getting serious as the TradFi giants start dabbling in his DeFi.
Whether the future of DeFi is utopian or dystopian is not for finance professors and practitioners to decide for themselves. A piece of software code that acts as a perfect contract leaves no room for a court to intervene if things go wrong, so, among other things, you have to imagine a not-so-sound ending to Shakespeare’s The Merchant of Venice. Legal and cultural philosophers should also bookmark the Eisenberg liquidation. They may have to join the discussion right away.
Details from Bloomberg Opinion:
• Will cryptocurrency be a safe investment?: Andy Mukherjee
• Beware of the dangers of too much cryptocurrency regulation: Tyler Cowen
• Beware of crypto billionaires who brag about audits: Lionel Laurent
(1) See the paper by Jakub Warmuz, Amit Chaudhary and Daniele Pinna, “Toxic Liquidation Spiral: Evidence from AAVE’s Bad Debt Suffering”.
This column does not necessarily reflect the opinions of the editorial board or Bloomberg LP and its owners.
Andy Mukherjee is a Bloomberg Opinion columnist covering industrial companies and financial services in Asia. He previously worked for Reuters, The Straits Times and Bloomberg News.
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