Welcome to the new financial system. Same as the old one?
On the face of it, the philosophical differences between centralised and decentralised finance (or ‘CeFi’ and ‘DeFi’, for short) are stark.
Under the CeFi system, central banks play a pivotal role as the lender of last resort. They can lower the price of credit and offer liquidity to dealers suffering strain.
Since the 2008 crisis, they have also bought assets in bulk from private entities to shore up the financial system. The US central bank’s balance sheet has expanded fivefold since 2008 as a result of this approach, called ‘quantitative easing’.
In recent days, the Fed has taken its interventions to unprecedented lengths amidst the coronavirus panic. It has cut interest rates to zero, launched a new $700bn asset purchase programme and offered up to $2trn in extra loans to the repo market.
under DeFi there is no formal backstop to the system
But under DeFi, the catch-all term for decentralised lending protocols, there is no formal backstop to the system.
This makes an immediate difference in the way loans are structured: in DeFi, they require much more collateral than those in the traditional financial market.
In the conventional financial system, a repo loan may have only a minimal ‘haircut’ (the margin by which the value of the collateral exceeds the value of the loan).
The Bank of England, for example, requires a haircut of only 0.5 percent for loans against short-maturity UK government bond collateral.
In a popular DeFi lending protocol, MakerDAO, the value of the collateral (in the form of cryptocurrency ethereum) is set at a level a hundred times higher: 50 percent more than the value of loans.
In MakerDAO, loans are made in a native ‘stablecoin’—a token with a notional 1:1 peg to the US dollar—called dai.
Dai has been greeted by DeFi enthusiasts as a decentralised alternative to centralised stablecoins like tether, which rely on a trusted third party to maintain their peg to a fiat currency unit.
However, last year analysts at blockchain.com pointed out that the lack of a central guarantor in the MakerDAO structure meant the whole lending system was vulnerable.
“Reliance on ethereum means that all dai are susceptible to large drops in a single cryptoasset’s price, creating single point of failure risk,” blockchain analysts wrote in a 2019 report on stablecoins.
Last week this warning proved prescient: the MakerDAO system’s 50 percent collateral margin proved insufficient in the midst of huge market volatility.
On Thursday, a plunge in the price of ethereum left the whole MakerDAO system short of collateral, with at least $4m of dai-based loans left unbacked.
One of the contributing factors to MakerDAO’s problems was strain on ethereum’s transaction processing capacity, with deals taking nearly an hour to be confirmed on the public blockchain, rather than the usual ten seconds.
This, in turn, led to stale price feeds, which caused the systems’ collateral pool to become depleted.
“Some dai holders are not happy. If they don’t participate their holdings get diluted”
As a result of the shortfall, MakerDAO has been forced to turn to a secondary funding mechanism, an auction of a native token called MKR, to recapitalise its system.
The auction will take place on Thursday March 19, when MKR will be sold in lots of 50,000 dai.
“The MKR token issuance can be seen as a form of insurance as last resort,” Stani Kulechov, chief executive at Aave, a decentralised money market platform where holders of tokens, including dai, can lend them out for interest.
“This is the very first time they’ve had to mint MKR tokens and sell them to the public to clear the deficit,” Kulechov said.
“Some dai holders are not happy. If they don’t participate their holdings get diluted. But that’s the purpose of the MKR token—to rescue the protocol,” he added.
Aave is one of a hundred members of a syndicate committed to underwriting the MKR sale.
“Our coalition of DeFi market participants is backstopping the auction,” said Kulechov.
While the number of dai tokens in circulation has dropped sharply since the autumn—the total dai supply on March 17 was 15.7 million, down from a peak of over 100 million in November 2019—the dai peg has stabilised, at least temporarily, since last week’s panic.
On Friday 13 March, according to coingecko.com, a single dai token traded at a 20 percent discount to its notional 1:1 dollar peg. However, on March 17 this discount had narrowed to 2 percent.
Meanwhile, the price of ethereum, the second-most traded cryptocurrency after bitcoin, has also found some short-term stability.
Having fallen from $280 to $100 in the course of three weeks, ethereum tokens were quoted at $117 in early trading on March 17.
While JP Morgan was initially seen as a hero, public opinion soon turned against him
Since it involves the voluntary participation of private actors, rather than state intervention, the MakerDAO rescue echoes a century-old financial crisis.
In 1907 a syndicate of New York bankers, led by JP Morgan, stepped in to quell a panic that had seen US stock prices fall by half.
While Morgan was initially seen as a hero, public opinion soon turned against him.
Following the crisis, the US House of Representatives’ Committee on Banking and Currency issued a scathing report, accusing the bank of insider dealing. The Committee pointed out that JP Morgan employees also sat on the boards of directors of 112 US corporations, representing 85 percent of the value of all US stocks.
The outcome of an ensuing wave of public indignation was the creation of a new kind of public body, a central bank.
By 1913, the Federal Reserve had officially replaced the JP Morgan-led ‘money trust’ as the US financial system’s lender of last resort. The bank’s eponymous founder died in the same year.
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