The sudden cut in loan term is a feature of decentralized financial markets, or DeFi, that allow volatile cryptocurrencies to be lent to each other. The trader borrowed the CRV token by posting USDC, a stable dollar, as collateral.
If this were ordinary debt, the borrower would be required to make a deposit when the lender was uncomfortable with the collateral covering it. On a public blockchain, anyone can monitor such situations. To keep the system secure, arbitrageurs are encouraged to participate. These are algorithms that raise so-called flash loans (more on them later) to liquidate vulnerable short positions. They pocket the rewards from software code — smart contracts — that run lending protocols like Aave.
While not directly related to Eisenberg’s loan, recent research by academic researchers has concluded that DeFi harbors a systemic fragility, in that liquidation creates other liquidation. Collateral prices are affected across trading locations; widespread discomfort. Flash loans are to blame – they’re so fast and frictionless that decentralized lending becomes crash-prone.
On the other hand are practitioners who believe teething problems are normal for a nascent industry. DeFi deserves a fair chance to create a cheaper alternative to intermediary-based traditional finance, aka TradFi, which — for all the advancements since jewelers– 17th century banking was born — still relying on expensive taxpayer-funded bailouts. Remember the subprime lending crisis?
In Eisenberg’s case, there was nothing remarkable about his own loss. The problem is that Aave, the platform, was saddled with $1.6 million in bad debt after the algorithms — taking advantage of the 75% increase in CRV on Nov. 22 — closed short positions. At first glance, this seems to be a point in support of the fragility hypothesis of economists Alfred Lehar of the University of Calgary and Christine A. Parlor, a professor of finance at UC Berkeley. According to them, an important difference between DeFi and TradeFi is that the former does not place any capital restrictions on arbitrageurs. Is that the problem? Yes, it can be.
DeFi borrowing and lending is anonymous. In the absence of a credit score, or recourse to the borrower or his reputation, the loans should always be worth significantly less than the collateral, especially since the token is being borrowed and the coin borrowed against can both fluctuate wildly. To keep the lending pool safe, algorithms scour digital platforms for violations of lending standards by value. When they focused on bad debt — Eisenberg’s position exceeded the system-set LTV of 0.89 on November 22 — they were programmed to look for a flash loan, using the proceeds to close a portion of the original debt, acquire the collateral, and sell it to relieve their liability.
Unlike conventional finance, these four things happen in a block of authenticated information. Transactions are executed in their entirety and all copies of the distributed ledger reflect that transaction or not at all. That’s why bots don’t need to bring capital to pocket their promised liquidation offer — 4.5% during the Eisenberg period. They do not pose any credit risk to the lenders who advance money to commit the murder. Lehar and Parlor note: “Expertise is more likely to be an obstacle than capital because of the existence of flash loans.
That’s the full score for capital efficiency. But we also have to factor in the cost of the lending system if there is no conflict. And here’s the crux of the “Where’s DeFi” debate: Was the bad debt left to Aave the result of a serious unresolvable flaw, or could a design tweak prevent it? get that?
In an article about the episode, a team of blockchain experts came up with a possible answer. Exceeded the threshold, the liquidation on November 22 turned toxic. Each forced closing of the loan made Eisenberg’s remaining position a bit riskier when compared to the available collateral. That, in turn, invited another bot and the whole thing spiraled out of control. If the 4.5% fixed liquidation offer had been flexible, if it had dwindled along with the thinning of collateral, the platform could have avoided any bad debt.
Jakub Warmuz and co-authors note: “Malicious liquidations are dangerous for the protocol because they mathematically guarantee that users’ portfolio health will deteriorate through no fault of their own. surname”. “As a general rule, sudden thoughtless responses to complex dynamic behaviors lead to worse outcomes than the response set out to achieve. They should be avoided unless absolutely necessary.”
Fixes need to come sooner rather than later. Not because our next mortgage will be DeFi — good luck with registering a city’s assets on a public blockchain. A key driver that is a large part of conventional commodity trade could benefit if decentralized finance allows a barrel of wine or Japanese yen that an importer owes to become an asset on the blockchain. So that money can be raised at a cheaper price than it is now after paying the middleman fees. In November, JPMorgan Chase & Co. executed a small transaction on Aave, taking the first direct spot on a public blockchain. With the TradeFi giants starting to dive into DeFi, the whole thing is getting serious.
Whether the future of DeFi is utopian or backward is not something finance professors or practitioners can decide for themselves. A piece of software code acts as a complete contract, leaving no room for the courts to intervene if something goes wrong, requiring us to imagine, among other things, a less happy ending. for Shakespeare’s “The Merchant of Venice”. Legal and cultural philosophers should also mark Eisenberg’s liquidation. They may have to wade into the debate soon.
More from Bloomberg Opinion:
• Will cryptocurrencies ever be a safe investment?: Andy Mukherjee
• Beware of the dangers of too many crypto regulations: Tyler Cowen
• Watch out for crypto billionaires boasting audits: Lionel Laurent
(1) See “The Toxic Liquidation Cycle: Evidence from AAVE Bad Loans,” an article by Jakub Warmuz, Amit Chaudhary, and Daniele Pinna.
This column does not necessarily reflect the views of the editorial board or Bloomberg LP and its owners.
Andy Mukherjee is Bloomberg Opinion columnist on industrial and financial services companies in Asia. Previously, he worked for Reuters, Straits Times and Bloomberg News.
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