Three things DeFi can learn from the financial crisis
Editor's Note: This article comes fromUnitimes（ID：Uni-times）Editor's Note: This article comes from
, by Nemil Dalal, translated by Johnny, published with permission.
Even if Satoshi Nakamoto created Bitcoin, he may appreciate the world created by Ethereum's decentralized finance (DeFi).
As of today, the value locked in DeFi is close to $1 billion. But as DeFi has grown, so have hacks, costing users millions of dollars worth of funds.
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The loss of funds caused by the hacking attack encountered by DeFi. Source: DeFi: Dependency Hell Meets Finance[1]
Although DeFi is very different from traditional finance, it still needs to grapple with the same three factors that led to the 2007 financial crisis:
yield chase
grab a chair game
In physics, it is impossible to get rid of gravity. In finance, it is impossible to escape the market. So let's delve into these three lessons.
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Yield Tracking Has Inherent Risks
Yield chasing was one of the earliest causes of financial crises. Low interest rates following the dot-com bubble led investors to chase higher yields in the form of subprime loans.
In finance, yields reflect risk. Today, investors can earn 80 basis points on Treasuries while earning 6% yields on riskier bonds. This difference (the latter has a higher yield) is to compensate for the risk that riskier bonds may not be able to repay their principal.
The challenge for investors is to determine which yields are opportunities and which yields are high because the financial product is inherently risky.
A mistake at the heart of the 2007 financial crisis was the misappraisal of risk in high-yield securities backed by mortgages. Subprime loans -- even the AAA-rated ones -- have never been watertight, although ratings agencies and mortgage originators believe otherwise. [Note: Subprime mortgages refer to loans provided by some lending institutions to borrowers with poor credit and low income, most notably housing loans, and the interest rate on subprime loans is usually higher]
DeFi has also encountered the same problem, and users compare the benefits of different DeFi protocols without paying attention to potential risks:
security risk
Mortgage rate
Mortgage rate
governance process
liquidation process
network availability
Unlike ICO (Initial Coin Offering), most DeFi projects bring limited benefits, although there are significant risks in DeFi. A "jackpot" ICO may bring a return of 5000%, while the potential loss is up to 100%; but for decentralized lending, the best case is that the return rate is between 10% and 20%. And if the DeFi protocol is attacked, the loss rate is as high as 100%.
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Everybody's playing a game of grabbing chairs
Chasing yield has created a vicious circle for banks and DeFi protocols, but that doesn’t stop everyone from playing the game.
As former Citigroup CEO Chuck Prince said at the start of the financial crisis in 2007:
"In terms of fluidity, if the music stops, things get complicated. But as long as the music doesn't stop, you have to get up and dance."
Essentially, organizations that manage risk carefully experience losses until they win. The market is a vicious cycle, which means that thoughtful CEOs are not rewarded until the market crashes and drives their risk-maximizing competitors out of the market. As Warren Buffett said: "Only when the tide goes out do you find out who's been swimming naked."
The same effect also happens on DeFi. For example, an easy way to beat the Compound protocol’s lending rate is to require a lower collateralization ratio, closer to 100%. Lower mortgage rates make these loans more attractive to borrowers (since lower mortgage rates mean borrowers have fewer assets to mortgage), increasing the rate of return they are willing to give savers (lenders). In a yield-chasing world, this competing product can quickly gain market share -- like Chuck Prince's Citigroup -- albeit with far greater risks involved.
This is a typical prisoner's dilemma:
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DeFi faces such a prisoner's dilemma
In the DeFi space, risk ratings are really only taken seriously when users lose their funds and start taking these risk factors seriously.
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everything is connected
During a financial crisis, no bank is isolated. Today, no DeFi protocol is an island.
Mistakes by Lehman and Merrill Lynch caused problems for the best-run banks. No matter how smart Goldman Sachs is at managing risk, it needs AIG (American International Group) to pay for the policy:
At the end of the day, finance is an intertwined house of cards:
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Goldman Sachs' top derivatives counterparties as of June 2008, source: Financial Crisis Inquiry Committee
In the DeFi field, the various DeFi protocols are similarly connected to each other. Compound relies on the MCD smart contract; PoolTogether relies on both Compound and MCD to function... As Coinbase engineer Daniel Que pointed out:
Due to composability, DeFi protocols can also become a house of cards.
Composability is one of DeFi’s superpowers, but also one of its greatest dangers. Just like in a financial crisis, even the best-run banks are not safe, a well-audited smart contract is not immune to interacting with all other protocols and primitives, especially those that were not deployed when their original code was deployed. Protocols and primitives for building.
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Never forget - finance is finance
DeFi is still in its infancy and is still a long way from becoming the foundation of the next financial system. But it needs to become anti-fragile if it is going to be fundamental to how finance works.
DeFi protocol scoring projects like DeFi Score can educate users about risks. DeFi protocols can write test suites to test for common dependency bugs. Protocols can be structured in a way that is resilient to unexpected failures. DeFi itself can offer insurance through protocols like Opyn.
At the end of the day, DeFi is not banking. It is open, permissionless, and programmable. But finance is finance, regardless of the tech stack underneath it.
