RelayNode SoCal: August 5, 2019 – Relaynode SoCal
#DeFi and Financial Contagion
This week saw increased debate regarding the DeFi ecosystem. I believe it’s an important conversation to have now, when there is only $450M locked in DeFi, before the ecosystem grows too large.
Joey Krug tweeted that there will be a DeFi financial crisis in the next few years by explaining that most DeFi protocols are still effectively centralized. A few months ago, I voiced similar concerns on this episode of Blockcrunch with Jason Choi.
But unlike Krug, I am not concerned with too much centralization. On the contrary, I think that this tweet storm by Kain Warwick of Synthetix addresses why some centralization in the early days of DeFi is important. In fact, Warwick’s case addresses what most concerns me about DeFi: financial contagion resulting from compounding technological risk.
Financial contagion can spread due to misunderstood counterparty risk. Counterparty risk, a subcategory of credit (default) risk, exists when one party or an intermediary to a derivatives contract can default on its obligation to pay.
In the 2008 financial crisis, insurance giant AIG, guaranteed tens of billions of dollars in derivatives contracts. As the value of the real estate collateral that ultimately secured these derivatives rapidly declined and borrowers defaulted, the insured discovered that AIG was incapable of meeting its obligations. Asset prices continued on a downward spiral and the insolvent company, facing a bank run-like scenario, was bailed out by the US government to the tune of $180 billion.
AIG offered a critical piece of infrastructure to the financial system and institutions that entered into AIG-guaranteed contracts completely mispriced their risk. AIG teaches us that mispriced counterparty risk is one potential cause of financial contagion.
One of the most lauded attributes of DeFi is its composability. Because DeFi protocols are open source, developers can leverage existing protocols to quickly create new applications. As an example, dYdX leverages Maker DAI for certain contracts while sourcing liquidity from relayers on 0x. But as Daniel Que from Coinbase pointed out this week, the dark side of composability is interdependency.
There are multiple counterparties in DeFi, but the ones to focus on are the smart contracts themselves. When a smart contract is your counterparty, counterparty risk is essentially technological risk. So how risky is it?
Because DeFi smart contracts are developed by start-up companies, one potential comparison for pricing smart contract risk could be the cost of venture debt. Interest rates on 3–5 year venture debt range from 5–9%, but in addition to interest, venture debt lenders often receive company warrants.
Assuming that that the cost of startup equity capital is 20–30% (cost of seed startup equity is likely much higher), the appropriate rate for taking smart contract risk grows to mid double digits.
Remember, that this hypothetical interest rate range is calculated before accounting for the credit (default) risk of the actual borrowers, who are often traders & speculators. With every additional protocol leveraged by a new smart contract, this counterparty risk compounds due to interdependency. To make matters worse, the automated nature of these smart contracts can lead to the rapid spread of defaults.
Some believe that because DeFi is an open and transparent system, that counterparty risk will be well enough understood to be mitigated. However, as the number of loans and derivatives contracts outstanding increases, the complexity of the ecosystem will only grow. Most risk models will be unable to navigate the chaos.
As an analogy, we mapped the full human genome by 2003 — that’s full transparency. However, 17 years later we are nowhere close to understanding and appreciating the complex interactions between the millions of base pairs of genes that exist. In fact, we can barely understand the inner workings of an individual chromosome which contains only 150,000 base pairs.
At this moment, I do not believe that the benefits of DeFi like overcollateralization and transparency are enough to help participants properly underwrite counterparty risk and for the industry to avoid financial contagion.
Following their post last week on the three vectors of (de)centralization: architectural, political, and logical, Multicoin announced their latest investment in Solana, leading a $20m round. Multicoin claims that Solana has solved the challenging technical problem of a smart contract platform that is logically centralized, but still both architecturally and politically decentralized. In this post, Samani highlights the tradeoff between sharding and composability, which he offers as the rationale for solving scalability in the way that Solana has.
The Fed cut interest rates 0.25bps as expected and global markets still pumped on the news.
To understand Bitcoin, one first must understand money. Nic Carter seems to always find and produce the best long reads. He shared this great one from the New Yorker on the history of money.
Larry Cermak released a report on the track record of the Initial Exchange Offerings. While some IEOs offered outsized returns to early investors with ATHs reaching 500% above listing, <50% have outperformed BTC. IEOs held on Binance have performed the best, but the majority of listings are already 50% below their all time highs.
This Week
CryptoMondays LA(Free)
When: Monday, August 5th, 6–9P
Where: Upstairs Space 1212 Restaurant on 3rd Street Promenade in Santa Monica
Crypto Traders Dinner Party ($5–10 donation)
When: Tuesday, August 6th, 7–9pm
Where: Panini Kabob Grill — Santa Monica, 312 Wilshire Blvd · Santa Monica, CA
Biweekly event to meet other crypto traders in the city and share experiences
Upcoming
Socratic Seminar with Coinbase Engineer
When: Wednesday, August 14th, 6–8pm
Where: WeWork Fine Arts Building 811 W 7th St · Los Angeles, CA
Eric Scrivner, Coinbase engineer, will be talking about forks, what they are, how exchanges can protect against them, and how to protect against their negative outcomes.
Bitcoin Is_ Hosted by NFL Pro Bowler Russell Okung (TBD)
When: September 1, 2019
Where: TBD
Hosted by NFL Pro Bowler, Russell Okun, Bitcoin Is_ is a one day conference with the intention of educating and onboarding new Bitcoiners.
Notable Conferences
August 17–18 — BitBlockBoom (Texas)
August 20–29 — Berlin Blockchain Week (Berlin)
September 8–15 — Tel-Aviv Blockchain Week (Tel-Aviv)
September 10–11 — DeFi Summit (London)
September 11–12 — Consensus Asia 2019 (Singapore)
October 8–11 — Devcon 5 (Osaka, Japan)
October 15–16 — Crypto Invest Summit (Los Angeles)
October 15–18 — Mondo (New York City)
October 21–23 — ACM: Advances in Financial Technologies (Zurich)
Nothing written in RelayNode LA is legal or investment advice and should not be taken as such. RelayNode LA does not make any guarantee or other promise as to any results that may be obtained from using our content. No one should make any investment decision without first consulting his or her own financial advisor and conducting his or her own research and due diligence.
Published at Sat, 31 Aug 2019 18:19:26 +0000
Bitcoin Pic Of The Moment
✅ This image from Marco Verch (trendingtopics) is available under Creative Commons 2.0. Please link to the original photo and the license. 📝 License for use outside of the Creative Commons is available by request.
By trendingtopics on 2019-03-11 22:13:54
