Offchain: Contagion

Offchain: Contagion

What DeFi giveth, DeFi taketh away AKA why unsustainable yield both started and killed the bull run.

Do you remember DeFi summer? That magical period in mid-2020 where people were chasing 10,000% yields, mining liquidity and getting rug pulled by food-themed protocols on a daily basis?

I mean, who could forget Tendies, a short-lived DeFi protocol based around an internet subculture dedicated to chicken tenders in which participants spoke to one another in a KFC Colonel-esque southern drawl. Magic!

DeFi summer was crypto at its best and worst: world-changing technological innovation delivered with all the maturity and seriousness of a Pauly Shore movie.

Well, two years on and DeFi has grown up, gone mainstream and – in an effort to prove that anything TradFi can do, we can do better – delivered a full-blown, GFC-style system-wide meltdown.

Vectors of contagion

The 2008 Global Financial Crisis was an exercise in contagion. The world of banking and international finance is so interconnected and homogenised that when the sub-prime mortgage/CDO market collapsed it was difficult to find an institution that didn’t have exposure. Which is how we went so quickly from Lehman Brothers to Everything, Everywhere, All At Once.

As it turns out, the 2022 DeFi market is built on similar foundations. Over the intervening two years, all the major players in the crypto lending space – Celsius, BlockFi, Luna, Lido, Voyager et al. – have created a daisy chain of highly complex and increasingly tenuous yield-bearing vehicles, where everyone is leveraging off everyone else to offer too-good-to-be-true interest rates.

But when the money stopped flowing and the losses started mounting, it turned out that much of the hundreds of billions of dollars supposedly locked in DeFi was imaginary. And that extricating customer funds when the customer wanted them was going to be more difficult than anticipated.

Defy CeFi

The result has been, well, this [gestures wildly at the burning hellscape]. While the crypto markets were tanking even before the LUNA-UST implosion, the subsequent liquidity snarls and liquidation cascades have pushed us into uncharted territory. Never before has Bitcoin dropped below a previous cycle all-time high, but here we are. Yay for us.

You can argue as to whether this is an issue with DeFi per se – decentralised protocols like Compound, Aave, Curve and Balancer are doing just fine – or with the centralised financial layer placed on top of it. Blockchain technology, as with most technologies, is value agnostic; it’s what we do with it that counts.

Greed and fear, humanity’s time-honoured weaknesses, have once again taken us to the edge. As FTX’s Sam Banks-Friedman argues, these are the cases where regulation could help us moderate the worst parts of ourselves. (FTX is also enjoying the role of white knight/crypto central bank right now, bailing out struggling lenders like Voyager and BlockFi with hundreds of millions in short-term financing).

Brutal as it may be – and the pain for retail investors is undoubtedly real and marked – it’s hard not to see this as a necessary humbling of a leverage-driven industry grown fat off the greed, profits and infinite money spigot of a two-year bull market. But leverage is an abstraction, the symptom of a market concerned only with itself. Only when it’s been purged will we be able to see what remains standing.

Luke from CoinJar

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