Remember the halcyon days of DeFi summer? Bitcoin was roaring, the Grayscale arbitrage trade was wide open, the basis trade was just getting going, traditional finance (TradFi) interest rates were plummeting and the broader public started to realize that a fully liquid 10% on stablecoins looked pretty darn good compared to the 0% offered in their savings accounts. Maybe we couldn’t point exactly to what was “alpha” in that spread, but numbers like that allowed us a fair amount of leeway in deciding that “this is a better way.”
Alex McDougall is president and CEO of Stablecorp Inc. This article is part of CoinDesk’s Crypto 2023.
In these early days, decentralized finance (DeFi) and centralized finance (CeFi) were yielding similar rates and there had never been a default in the industry because all loans were far overcollateralized and there was real economic value in posting bitcoin (BTC) as collateral and borrowing stables or fiat. Liquidity was also well matched because all loans were “open term” and any redemption requests could be met by liquidity on hand or calling back loans. I wrote a year in review article for this very series in December 2020 that I still stand by, mostly outlining why the industry worked based on the above dynamics.
Smash cut to today’s smoking wasteland of shattered dreams, shattered trust and near-zero yields. What happened? Was any of it real? Most importantly, what’s next?
Let’s spend the minimum amount of time on what happened because, honestly, it’s relatively simple, and the bad actors and details will be extensively documented in court cases for decades to come. The (criminally) short version:
- The arbitrage opportunities dried up. Spot exchange-traded funds (ETF) came out in Canada and caused all the closed-end funds to trade at a discount, wiping out the Grayscale trade and exposing some cracks in “lending” models at certain platforms. The basis trade is roughly correlated to BTC and is wider when prices rise, so the price turn in May 2021 caused the basis trade to start closing up. It opened and closed throughout the rest of 2021, but by the start of 2022, with basis yielding low single digits, the easy sources of yield were gone. [Grayscale is a CoinDesk sister company.]
- At this point, DeFi yields dropped precipitously and have stayed near 1%-3% on stablecoins since then on the bigger platforms including Compound and AAVE. However, CeFi yields stayed in the high-single digits (red flag number 1!) as CeFi platforms slowly began to erode lending/deployment standards to move up the risk curve to keep yields high. This took the form of lower credit quality, lower collateralization, direct deployment into arbitrage trades, yield farming or unproven projects like Anchor, locking up assets for term or, in the worst case, straight up fraud.
- Ultimately, you can’t hide in DeFi but you can in CeFi, and that’s what happened in the end. When the arbitrage opportunities dried up, DeFi yields dropped algorithmically and assets under management (AUM) did as well, while CeFi yields stayed artificially high and AUM plowed in until it didn’t and it all ended in tears. There’s a bigger point to be made here about how DeFi platforms aren’t shareholder value maximizing machines and CeFi platforms are, but I’ll save that for another article.
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Credit fundamentals matter
Very little in digital asset yield land is truly “new.” Most of the lending models that were “created” or popularized through the rise of DeFi are actually just more public versions of models usually executed deep within gigantic financial institutions – securities lending being the main one.
However, in the zeal to dispense with links to Tradfi, the fundamentals of operating those models – asset liability matching, correlation and contagion risk, collateralization models and robust underwriting models – got left by the wayside. While blockchain technology makes the operation of these pools and models much more transparent, effective and efficient (whether CeFi or DeFi), these are not technology platforms. They are financial risk trading engines, and the finance part of DeFi cannot be forgotten.
DeFi fundamentals like transparency are a must
Trust has been shattered in the digital yield space. Platforms that have gone through bankruptcies or have cut off liquidity will likely never recover, and this will leave a very long lasting impression on those looking to redeploy into this space. The “I pay you 12% and you don’t ask questions” model is gone for now (although never say never …). The first step in creating new models is a step function improvement in transparency. It has always been shocking how opaque lending platforms have been in an industry as transparent and “on-chain” as blockchain. Fortunately, because of that very same transparent nature of blockchain, quite a bit of knowledge can be gained about loan books, volumes and liquidity from an outsider’s perspective, simply by monitoring on-chain flows from known wallets.
Going forward, there will be a significant amount of pressure on purely CeFi companies to disclose more information about their loan books and asset deployment strategies. There will also be a greater use of on-chain analytics tools to bootstrap that transparency where it is not forthcoming.
There is also an entirely new model that has sprung up around this desire for transparency, colloquially known as “CeDeFi,” which refers to CeFi-style lending using DeFi rails. With this type of platform you have (mostly) the same level of transparency as a DeFi platform (i.e,. you can see the full loan book in real time including named borrowers) as well as any collateral posted and some summary risk scores on the borrowers. Borrowers are underwritten by “pool delegates” – third parties who do the diligence and also stake “first loss” capital into the pool to align incentives.
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Underwriting is getting ready for its time in the sun
One critical evolution in this space has been the bifurcation of two schools of thought and action around collateral. Collateral, particularly in DeFi, has always been used as a hack or replacement for underwriting. You don’t need to underwrite a borrower on Compound if they are posting 150% of ether (ETH) that will be liquidated at 120%. However, at the same time, it was constantly acknowledged that collateral was inefficient and exclusionary by nature. To participate in DeFi, you needed to already have assets to post as collateral, and with overcollateralization you are by definition taking assets out of circulation.
Before the meltdown, the truly institutional lending desks already had quite sophisticated underwriting processes for their counterparties, and the ones who followed them generally stayed out of the news. Now, with the increased push in transparency, underwriting practices are coming to light like never before, and with increased default data it is becoming possible to battle test these models and begin to build legitimacy.
There are novel structures coming online to help managing tail risk
There have been other novel structures that have sprung up in the lead up to and in the aftermath of the meltdown to help manage the tail risks associated with this type of relatively new exposure.
The first is DeFi insurance such as Nexus or Unslashed. Effectively, DeFi insurance acts similarly to any other insurance policy where an event happens and you are able to file a claim for compensation. Except instead of an insurance company underwriting and selling you the policy, it is an insurance pool that you are buying insurance from and the providers of the capital are other participants on the platform. If you put capital into a pool and it is bought out as insurance on the other side, you cannot remove your capital until either someone else puts in new capital or an insurance policy is cancelled. In this way, all policies are always fully reserved with assets. These platforms are new and they are certainly not Lloyd’s of London, but they do work. With the UST depeg there are now myriad case studies of users covering their risks via these insurance policies.
The second is tranching-type structures like that employed on Idle Finance. Idle employs a methodology where it takes exposure to underlying CeFi and DeFi yield generating pools (and CeDeFi pools) and tranches the exposure between a junior and a senior tranche that are priced differently. The idea is that in a loss scenario the junior tranche is eaten away first before any losses are passed onto the senior tranche. To a certain extent, this type of tranching plays the same role as collateral in that there is a support system of assets pledged to the senior tranche that is eaten up first.
There are ways to optimize yields that add limited risk
When everything is transparent and written out in code, platforms become infinitely “composable” and it becomes possible to build optimization layers or additional incentivization layers on top of other platforms. Morpho Labs is a great example of this. It takes the core engine of platforms like Compound or Aave and enhances the matching engine to turn it into a P2P network that both increases yields as well as decreases borrowing costs purely by improving the technology instead of stepping up any risk or duration curves.
DeFi rails on top of TradFi yields are an important part of modern yield portfolio
Finally, it’s crucial to examine the current reality and build models for resiliency. TradFi yields are now routinely higher than what is available in the arbitrage-driven digital yield space. This likely won’t always be the case but it may be for some time. So breaking down those barriers between the structures able to access arbitrage-driven yields and those accessing TradFi yields, particularly “risk-free” type yields, becomes an extremely valuable source of advantage for the next generation of digital asset yield products.
Setting a risk and yield floor with the TradFi market and opportunistically seeking to enhance that yield with composable, optimized, underwritten, appropriately collateralized, insured, transparent digital yield solutions is what will bootstrap this next generation of yield platforms.
Finally, it will take time to rebuild, but don’t quit on the yield space. There will be more arbitrage, there has been exponential infrastructure progress, there is more and more data to train appropriate risk models and there are more and more innovative ways to manage unique and tail risks inherent in the space. The first inning ended with a fastball to the shin, but crypto has survived utter devastation before and the yield industry will rebuild itself faster, more efficiently and more composable than before.
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