DeFi; GROW or DIE

The personal views expressed by the author in the below article should not form the basis for making investment decisions, nor be construed as a recommendation or advice to engage in investment transactions

DeFi has a big problem

The LUNA-UST loss is a reported $20B where word of USTs demise reverberated through US media.

The losses in DeFi due to exploits is eye watering. Billions of investor money vanishes each year. The top 10 exploits to date are a whopping ~$2.5B.

Let us put this into context. The Bernie Madoff scandal was $~$65B, Bill Hwang scandal~$36B; and now they’re saying “The DeFi scandal is more than $23B. And growing!”

It is naive to think there won’t be consequences for such size of financial losses in Crypto!

A leaked draft of the “Lummis-Gillibrand” cryptocurrency bill, if true, represents a rude awakening for DeFi.

TL;DR — Lummis-Gillibrand cryptocurrency bill proposal:

Mandates 100% Backing of Stable Coins

NFTs are New Asset Class

ETF Regulators to Govern Cryptocurrency

The mandate to 100% back Stable Coins with cash or cash equivalents and regular auditing would not pose a problem for USDC, BUSD, TUSD or USDP who represent $74B of value in a $160B Stable Coin market.

Another $72B of value stems from USDT.

I’m sure by the time they need to answer to the CFTC (ETF Regs to govern cryptocurrencies), they will be able to demonstrate $72B in cash or cash equivalents.

Am I right? Am I right?

So $146B of the Stable Coin market probably gonna be OK. (How much cash is backing Tether is still not confirmed!)

There’s still at least ~$24B (remember context above Madoff, Hwang, DeFi) of exposure to DeFi of which ~$11B of value comes from “Collateralised Debt Position (CDP)” protocols governing Stable Coins such as DAI, FRAX, USDN, USDD, FEI, MIM, LUSD and alUSD.

Why is that a problem you ask?

The current adoption of CDP protocols is that each of DAI, FRAX, USDN, USDD, FEI, MIM, LUSD, alUSD et al fall short of Lummis-Gillibrand proposal to enforce 100% cash backing of aforementioned Stable Coins.

These tokens will not be deemed cash according to Lummis-Gillibrand. If they’re not cash in the US of A, they’re not cash anywhere!

But what about the assets backing DAI (Cryptocurrency), FRAX (FXS), USDN (WAVES), USDD (TRX), FEI (TRIBE), MIM (Cryptocurrency), LUSD (ETH), alUSD (Cryptocurrency)?

Before we move any further, let us make some important distinctions of mechanisms of DeFi protocols that underpin ~$24B in perceived value that is exposed from shifting regulations in the US.

Money Market Protocols in DeFi Today

Anchor protocol was the underlying technology that supported the Terra ecosystem. Anchor is a decentralised money market (lending) and savings protocol, where depositors of UST stable coin would be rewarded in 20% annual interest and borrowers could deposit LUNA or ETH to take loans in UST.

On some occasions depositors of LUNA would be paid for taking UST loans. Yes you read that correct, at one point you could deposit collateral, take a loan and be paid for taking the loan.

Too good to be true Bernie, Bill, Do Kwon.

Am I Right? Am I Right?

Anchor is what I referred to earlier as a CDP — Collateralised Debt Position — protocol. With Anchor you could collateralise your staked position of LUNA and ETH, to take loans in UST (Terra USD Stable Coin).

Similarly, MakerDAO that governs the DAI stable coin is also a CDP protocol. You can deposit assets such as Bitcoin, Ethereum, ChainLink and other volatile crypto assets to borrow DAI. How much you can borrow is limited depending on the collateral you deposit, thus making DAI an over collateralised but backed by a basket of crypto assets and stable coins.

Around half of DAIs value is backed by cash equivalent (USDC). That’s $3.5B in DAI value that is exposed to the Lummis-Gillibrand bill.

Other CDP deployments of FRAX, USDN, USDD, FEI, MIM, LUSD, alUSD et al also carry marginal cash backings in USDC and are also exposed to US regulations.

Justin Sun launched USDD almost exactly recreating the UST model where TRX is the reserve asset along with BTC. Just like the rest is EXPOSED too! Backing your stable coin with an asset that is both acting as governance token as well as reserve asset simply doesn’t fly anymore according to messers Lummis and Gillibrand.

All these smart contracts that perform underlying lending functionality to distribute a stable coin are:

• not 100% backed with cash
• not deemed cash according to the US regulators
• exposed to bank run risks as seen with the LUNA-UST scandal

(Disclaimer: Isolated lending protocols within FRAX, FEI, MIM and alUSD are likely to fair better in pivoting to cash equivalent backing of their stable coins. FEI (or TribeDAO) are reworking Rari Capitals fork of Compound to deliver isolated ERC4626 vaults. MIM is based on Sushis Kashi isolated lending vaults and FRAXs AMO model enables all of them to move fast on recalibrating their collateral to back stable coin value with USDC/TUSD)

DeFis Big Problem?

There’s at least (a minimum of) $24B in Stable Coin value exposed by Lummis-Gillibrand of this amount only $4B in cash backing available.

The safest solution for DeFi would be all borrowers in these protocols de-levering the $20B in unbacked stable coin value. Majority of this $20B will be backed by cryptocurrency assets such as BTC, ETH or TRX (USDD).

In bearish market conditions where price of BTC, ETH and ALTs are losing value fast, coupled with such “un-backed stable coins” de-pegging (losing value against the US dollar), liquidation cascades can ensue. DeFi would lose more value as a result, more narratives to add fuel to the “DeFi Scandal”.

However much of Tethers value is not deemed backed by cash, will only add to this exposure and exacerbate DeFis problems and even more FUD for DeFi.

Systemic Risk

DeFis systemic risk is the underlying technology used in money market protocols.

Remember the CDP Protocols that much of DeFi is underpinned by? Where you deposit some cryptocurrency collateral and get a loan in a stable coin?

Each of these protocols will either need to change all collateral requirements to be 50% USDC (cash equivalents) or completely pivot their technology to new mechanisms for stable coin issuance and governance.

The Copy Pasta trend in DeFi has stunted growth. The DeFi circle jerk is coming full circle, beyond the few innovating, the same old model is being regurgitated and now regulations are catching up and catching these motherforkers out!

If DeFi doesn’t GROW, if DeFi doesn’t INNOVATE, if the Tech underpinning DeFi doesn’t EVOLVE; then DeFi will die and we will be left with CeFi through custodians and CEXs.

Viva la DeFi