Y Love & Y Fear DeFi

Let’s untangle DeFi and any potential disasters, alongside its search for utopia. 

Notable conclusions 

+ DeFi will probably grow 10/20x larger within T- 5Y

+ Stablecoins will act as the de-facto risk balancer, moving towards Basket-backed – creating a supply glut for governance coins. Tether is already bulk buying Tier 2 coins. 

+ Eth will be the dominant Crytpo cash currency moving forward, and Bitcoin will be its gold (Depending on the success of the merge)

 + Coins such as Comp, Avalanche and UniS could become collateral kings and queens with overbearing responsibility. The Prism protocol could subdue some collateral issues e.g liquation risk. 

+ ICOs should go past the IPOs listed on TradFi (58,000) within the year. Will be a big moment for DeFi. 

+ Crypto Selling will consistently decline slowly over time, leading to more stable prices and less volatility. However, crashes will be more brutal. 

Defi is already such an elegant and mature being.

So much so, that it shouldn’t be called Defi, but DeMa (Decentralized Markets) instead. 

Traditional markets are not called ‘Central Finance’, they’re called Financial Markets. It may seem like a small detail, but it points to what DeFi or DeMa is. It’s the web3 version of currency, money markets and capital creation. It’s a whole new layer of financial markets, on top of traditional markets. 

Some may argue that it’s an extension, which is plausible, but DeMa has its own of everything. It does not necessarily need to rely on Traditional markets. It has its own heart with cash equivalents, derivatives, discount rates, liquidity providers and exchanges, which makes it a whole new powerful being, one that is maturing. 

(This meme should really be everything DeMa and TradFi as CA. But you get the idea.) 

But before DeMa becomes a teenager and there’s no way back, it must be tamed. 

If traditional markets were to be remade today from the ground up, they would look very different. TradFi policy has used the point-in-time approach and ignored the through-the-cycle method for far too long. The consequences being that capital markets are overly complex, sensitive and do not necessarily benefit society. 

The essence of financial or capital markets is to deliver liquidity to those who need it most and who can use it effectively. It is there to bring borrows and lenders together to help fund projects that create the type of future they want. Yet, many are left out of this in practice.

With DeMa, we have a second chance to get it right from the start and use the network to allow anyone to participate in the governance of their own future.

However, there are issues with the way DeMa is heading. There are also recent notable sightings of 2008 FI dynamics. 

ABCs

-        People regard Bitcoin as a risky asset to hold

-        Defi protocols regard Bitcoin as a safe asset to hold

Who is right? Probably both. 

As most Defi protocols have lock periods, they’re usually forward looking, meaning that when writing the applications code or contract rules, they’re anticipating what bitcoin will be doing beyond 1Y. For the rest of us, Bitcoins price action today and yesterday are the most prominent features when perceiving the riskiness of the asset. 

There is therefore a lag and assumption from decentralized protocols that bitcoin will be extremely more stable in the future. Sadly, (If you hold Bitcoins) It probably means the previous high levels of price growth have ended, for anyone hoping for the moon.  

Though Eth is not Bitcoin…

To better visualize these risk weighting views, we can look at how DeMa is classifying bitcoin as a haven asset, similarly to gold or T-Bills in the tradFi sense. 

Using the Compound, Aave and Maker liquidity markets as examples, we can see how bitcoin and Stablecoins are being used in a similar way to risk-free assets. These are some of the largest protocols within Defi, so it is likely that their structure is echoed across the space. 

It is also important to note that Bitcoin's presence in Defi will also be in a wrapped version – WBTC, which brings it into the ERC-20 standard and thus into the world of DeFi. 

For the purpose of having a granular view, Eth holdings will be left out of the figures, as we do not need to understand why Eth is being held. It is the first native currency of DeFi, which will mean most protocols will need to hold substantial volumes anyway.

USD Coin (USDC) makes up 21% of Comp pool activity which is substantial. DAI makes up another 17% and WBTC makes up an additional 15%. That means half of Compound’s liquidity is made of relatively low-risk assets. 

Compounds Liquidity

However, this is nowhere near the risk-weighting of Makers' market, where 97% of all coin liquidity is in wrapped Bitcoin or Stablecoins. Aave also follows this. 

What does this mean? That Crytpo (especially DeFi) is safer than we think. Too safe in fact.

For the Defi market to evolve, it needs to embrace the idea of segmented risk markets, just like tradFi does, where market participants can choose how much risk to take on, similarly, to picking a point on the yield curve. Therefore, altcoins such as Avalanche, Yearn, Cosmos & Curve could see some initial increases in demand, for practical use rather than speculation.  

This is because of one nasty word – Inflation

As Defi/DeMa evolves, certain coins are likely to cement themselves as go-to collateral coins. Whilst Wrapped Bitcoin/Eth and stablecoins will make up most of this, there will be a need for an inflation hedge which these coins are unlikely to help with. 

As the whole idea behind stablecoins is that they peg to a fiat currency at 1:1, any inflation is likely to eat away at collateral positions. Therefore, Tier 2 coins such as Curve and Comp will likely act as a suitable balance in this space, as they offer yield and price appreciation.  

Along with the push towards the Proof of Stake convention and the anticipation of increased growth of new protocols, it is likely that the supply of tier 2 coins could also dry up. As Defi matures, large players in Defi or ‘Whales’ are likely to use a wide range of tier 2 and potentially tier 3 coins as collateral to borrow native coins on any blockchain. This is essentially yield farming in today’s concept, but tomorrow's concept could be – stake-farming – a way for whales to hold as much native coin as possible, to increase its fee volumes. 

Furthermore, the voices seem to be getting louder for a move towards basket-backed Stablecoins instead of one endpoint currency. Basket-backed would mean an endpoint backing of multiple sovereign currencies such as USD, EURO & GBP. It is also likely to include numerous on-chain assets as well. If this ends up as the case, it is likely to only increase the demand for tier 2 coins, as a situation is likely to occur where stablecoins are backing other stablecoins. Sounds pretty sus and gives 2008 Fi vibes, but in theory it works.

However, this could effectively lead to large unsustainable price increases in these coins, followed by overwhelming drops. These drops could break DeMa, if too many whales are exposed. 

Ironically, Defi’s current high ratio of safe assets to riskier assets could be the reason for its downfall. 

However, the maths behind the PRISM protocol could aid the market with these collateral problems. One of the issues with DeFi collateral is that you are always prone to liquidation risk (and impermeant loss if you’re in a paring liquidity pool). The mentioned brutal drops are made possible by market-wide liquidation.  

Imagine you do the following.

·  Borrow 1,800 USDC on Compound by leveraging 900 DAI (that had been deposited before) – Your initial DAI is now at risk of liquidation if the price moves against you. 

·  Swap 1,800 USDC For 1,788 DAI On Curve.fi 

·  Get a reward of 0.00000271 COMP for supplying DAI on compound (not claimed)

·  Swap 1,788 DAI For 86,734 cDAI on Compound. 

This is a common example to receive coin rewards, airdrops and increased yield, yet liquidation can change what you’re at risk too extremely quickly. 

The way that DeFi lets users borrow against many crypto coins without any other assessments or funds, is that the lender will take away the collateral if the price of the collateral falls below a threshold. If this happens, you keep the original lent asset, but lose the borrowed-against asset. 

In this example, the original DIA is at risk of being lost. If this happens, you could trade or Swap back the cDAI back to DIA, but possibly at a worst rate. 

The PRISM maths removes the chance of liquidation, by using lock periods and monetizing future yield. It sounds dodgy, but it does make sense. 

Prism came up with a way to bring the equations used in interest rate swaps over to the blockchain, to eradicate this risk. Essentially, they allow you to split your collateral up into two new coins – The Yield coin (yLuna) and Principal Cashflow (pLuna) Coin. Therefore fixing the yield Interest rate, hence why it was used from interest rate swaps, as the interest was previously variable.

From this, you can instantaneously use the yLuna as effectively the collateral coin to which you would borrow against, like another protocol. However, conversely with PRISM, you now have the pLuna coin which you can go and use as you please. You’re effectively making more use of your assets/money than before. 

Yet why would PRISM allow you to keep collateral that could be worth nothing, if the price of it dumps, whilst you’re out there splashing your new crypto into other liquidity pools? 

They get around this by bringing future yield into the value of the yluna coin. They are therefore assessing future cashflow, but at what rate? 

Arguments for the correct discount rate for PRISM belong to an entirely new thread, yet the principals of this project could work in the wide scheme of DeMa. 

What happens next is always a mystery, yet the risk structure of DeFi is pointing to a positive future, one where it has a purpose. Though there might be a few bumps along the way.

✌️