The collapse of the capital market marks the arrival of the DeFi era

On the surface, last Thursday was a bad day for DeFi.

Most notably, MakerDAO’s “keeper” system broke down, partly because collateral was being liquidated so quickly and partly because trading volume hampered Ethereum’s performance. All in all, the liquidation process did not go as expected, resulting in many lenders being fully liquidated (over and above the expected 13% penalty), and MakerDAO needing to auction off debt to make up the $5 million difference.

Combined with the previous flash loan attack incident, many people have questioned the development of DeFi. Some people want to know whether this ecosystem can fully protect itself and whether it can be trusted.

DeFi is becoming anti-fragile

Those in the DeFi industry already know that the ecosystem is still under development. When conducting a stress test like this, many would assume that the concern about MakerDAO would be its ability to continue to maintain its peg to the dollar, rather than the handling of liquidated collateral. In fact, as DeFi innovation continues and the attack surface increases, many in the industry are worried about a financial disaster far more serious than MKR's $5 million shortfall.

Within 24 hours, many public pledges had been made to participate in the MKR debt auction from well-capitalized sources, and a DAO emerged that would manage a pool of capital that could act as a “last resort” if this were to happen again in the future. Within 72 hours, a proposal to add USDC to ease liquidity concerns surfaced.

Perhaps the headline should be how well DeFi performs in this stress test that only comes every few decades, and how quickly the ecosystem adapts and becomes anti-fragile.

This is the first time we can make a direct comparison between DeFi and existing capital markets. What is not clear is that despite its obvious flaws, DeFi is already better than the status quo in key areas.

Cracks appear in capital market infrastructure due to lack of liquidity

As Neil Irwin of The New York Times put it in his article titled “Something Weird Is Happening on Wall Street, and Not Just the Stock Sale”:

“It has been a troubling week for global financial markets, not least because of the sharp sell-off in equities that ended a more than decade-long bull run.

Beneath the numbers are a host of movements that suggest some part of the financial system is breaking down, even if it’s not entirely clear what that is.”

Although Irwin suggests otherwise, the problem is clear:

“There were also reports from trading desks that many assets that are normally liquid — easily bought and sold — were freezing up, with securities not being widely traded. The same was true for bonds issued by municipalities and large corporations, but more bizarrely, for U.S. Treasuries, which normally serve as the bedrock of the global financial system.

It’s fair to say that people are concerned about liquidity in the bond market.”

This Bloomberg article puts the issue more directly in its headline: “Wall Street’s Nightmare Is All About Liquidity”:

“As the novel coronavirus continued to spread this week into a pandemic, financial markets were thrown into turmoil and renewed concerns about their ability to function in times of crisis.

The evaporation of liquidity is evident across nearly all asset classes, but it’s most pronounced in securities that typically act as safe havens, whose prices rise during periods of market turmoil. That’s led to strange, unsettling moves as traders see long-established cross-market relationships unravel.

Untangling all the sources of the various stresses in the market may be difficult, if not impossible. Still, huge demand for dollars from companies and investors is cited as contributing to the drying up of liquidity. Many companies have been forced to tap emergency credit lines from banks to ensure they have enough cash on hand to continue operating as their revenue streams threaten to dry up.

The technology underpinning DeFi disrupts liquidity-related issues

While other aspects of DeFi have withstood stress tests, decentralized exchanges have shined.

Last Thursday was a record day for both Kyber and Uniswap, with ETH/DAI liquidity providers seeing positive returns during the height of volatility despite concerns about returns in volatile markets.

Dydx had seen rapid growth before last Thursday, while more stablecoin innovations are coming online.

The Fed has invested more than $2 trillion on liquidity issues without making much progress, and many central banks seem to have realized that digital currencies could be the answer.

It is becoming increasingly clear that legacy capital markets infrastructure is unable to support global liquidity needs, and the DeFi ecosystem is bringing substantial innovation to the problems caused by this shortcoming.

The importance of transparency

Another important context is the impact of transparency that comes with open source financial markets. Most startups don’t have their bugs revealed in public, nor do other startups have bugs that cause their beta testers to lose money. Except in DeFi, all receipts are public.

At this point, does anyone believe in what is happening in the repo market?

In September 2019, the Fed provided $500 billion in temporary intervention in the repo market that was supposed to last a few weeks. This was the first time the Fed had intervened in the repo market since the Great Depression.

Last Wednesday, six months after that intervention, the Fed still had $500 billion on its balance sheet. Then last Thursday, the central bank announced it would pump another $1.5 trillion into the repo market, though that did little to stop the bleeding. On March 17, the repo market saw another $500 billion intervention.

Where did the $2 trillion come from? This was supposed to be a temporary program of $500 billion for one month, but now it is at least $2 trillion, and it will increase in six months.

What don’t we know?

Who saved whom?

What is the cost?

Are we returning to an era of socialized losses and privatized gains?

Now another $700 billion stimulus package? $2 trillion here, $700 billion there, and soon we'll be talking about real money.

Or do we just not know what “real money” is?

Based on this, we will learn some valuable lessons about the value of transparency in financial markets.

DeFi is the future

One of Ray Dalio's investing principles is:

“Identify the paradigm you’re in, examine if and how it’s unsustainable, and envision how a paradigm shift will occur when the unsustainable stops.”

We can watch this all unfold in real time. It’s certainly possible that capital markets infrastructure can rebound and better weather the coming storm, but such bets don’t inspire much confidence.

Even more modern fintech startups like Robinhood and Bitmex face challenges dealing with this level of market volatility.

As traditional infrastructure increasingly breaks down, the value of a new programmable capital markets infrastructure becomes more apparent.

Broadly speaking, DeFi as a technology is currently closer to alpha than beta. However, in many ways, it had a historic day in the financial markets, even better than more traditional financial services and providers, which performed quite badly. While DeFi still has a long way to go before it matures, at the current rate of innovation, it may become a better product sooner than most people think.