Is Decentralized Finance really all that decentralized?
A limited number of investors and users are reaping all the rewards. Makes you wonder if this latest spin on “financial innovation” introduces more risk without changing much.
Meet the new boss, same as the old boss…
One of the most popular buzzwords trending in the financial press is DeFi. DeFi is defined as providing financial services and products on the blockchain without having to use a middleman such as a bank or brokerage.
What’s in a name? DeFi is short for Decentralized Finance, a name that highlights its main alleged advantage to users. The primary benefit of DeFi, say touters, is that a wide array of consumers have access to it without having to rely on — or risk interference by — a centralized governance body or authority like a sovereign central bank.
However, DeFi may not be as decentralized as its promoters would like you to believe.
The table below displays several of the top DeFi protocols based on the metric “Total Locked Value.” Total Locked Value represents the dollar amount staked in a protocol. A small concentration of venture capitalist are dumping their investors’ dollars into the majority of popular DeFi protocols. In many cases, the venture capital firms are investing in competing and overlapping protocols that provide much of the same function.
Some firms that have been most outspoken about the benefits of DeFi — Andreessen Horowitz, Coinbase Ventures (a unit of Coinbase), and Union Square Ventures — are the biggest players. Together with a few other investors the Total Locked Value for the top ten Defi project represents around $97B out of $159B for the top 463 Defi projects. That’s roughly 61% of the list.
Firms like Andreessen Horowitz, Union Square Ventures, and Coinbase’s venture arm — Mark Andreessen and Union Square Ventures’ Fred Wilson are major investors and sit on the Coinbase board — are playing a very traditional lobbying and revolving door game by hiring former government regulators and lobbying firms such as Franklin Square Group, Mayer Brown to expand and protect their dominance in the cryptocurrency space. These firms are also making significant direct campaign contributions to legislators to make sure any regulation is tailor-made. Even the New York Times has noted the willingness of Andreessen Horowitz to play politics to dominate the space.
The Silicon Valley firm Andreessen Horowitz, whose founders played big roles in the development of the internet, aims to own a huge part of the digital currency world — and set the rules for it, too.
If the same small cadre of investors and their investment firms fund the top protocols, is Decentralized Finance really that decentralized?
A small concentration of investment firms managing a majority of potentially interrelated companies is nearly a mirror image of today’s traditional institutional financial system. For example, the top 6 banks in the US control roughly 50% of the asset value of the top 250 largest banks in the US.
Is DeFi really that much different?
Policymakers might note that the concentration of investors and investment also translates potentially to a concentration of risk among DeFi protocols. Are we running into another “too big to fail” scenario? Where is the SiFi designation when we need it?
Several of the best-funded protocols such as Maker, Curve, Aave, and Compound are known as liquidity protocols and offer services similar to a traditional retail bank. These protocols in the DeFi space allow users to deposit tokens and to take out loans. Often the interest rates for individual depositors are higher than they would find at a traditional bank and loan terms possibly more favorable to borrowers.
Liquidity protocols suffer from potential security vulnerabilities such as hacks or erroneous payouts to users, but also suffer from some of the same problems traditional financial institutions face. Coinbase is a crypto asset broker and a custodian, introducing conflict of interest risk. Robinhood, another broker that allows digital asset transactions, suffered a data breach in June of 2021. SushiSwap’s main creator stole and returned $14M from users.
In May of this year, a DeFi protocol known as IronFinance experienced what amounted to a bank run. How different was the experience for IronFinance’s customers from customers who have experienced a traditional bank run?
More recently, DeFi protocol Aave experienced a large drawdown by investors.
For comparison, in 1998 Long Term Capital Management (LTCM), led by Nobel Prize winning economist Robert Merton and a slate of high-profile Wall Street traders, established a hedge fund that for the first several years produced large returns. The LTCM strategy relied on heavy leverage and pursued an arbitrage bond trading strategy. Unfortunately, the strategy unraveled when Russia defaulted on its debt and Asia went through a financial crisis. The U.S. government came to the rescue by arranging a “voluntary” private bailout by a multitude of banks. In short, the government worried that without a bailout the collapse of LTCM presented untenable systemic risk.
Is it possible that DeFi protocols to suffer the same fate, forcing the government to step in?
A closer look at concentrated risk – Compound Finance
On any given day it seems like dozens of new DeFi protocols are unleashed with a flurry of public relations and perhaps manufactured market activity. Volumes could be written to analyze each, but let’s focus on Compound Finance.
Compound is a popular protocol and backed by several of the top VC firms. The firm describes itself as “an algorithmic, autonomous interest rate protocol built for developers, to unlock a universe of open financial applications.” In short, Compound is a protocol built on the blockchain that provides traditional financial resources such as banking and an exchange to users.
Moreover, it’s a prime example of a DeFI Protocol that looks more centralized than one might expect. The chart below shows that the majority of its ownership is made up of Whales (60%) versus Investors (33%). Whales are investors or groups of investors that hold a large amount of digital assets.
Do the whales in the graph below represent the largest VC and similar investment firms? Retail crypto investors are a small slice of the pie on the Compound platform. And, in the case of Compound, the voting rights for the protocol are dominated by the major VC firms providing capital along with Robert Leshner, the Founder of Compound.
A spokesperson for Andreessen Horowitz, also referred to as a16z, responded to a request for comment with, ”No comment.” Spokespersons for Union Square Ventures and Coinbase/Coinbase Ventures did not respond to a request for comment.
Too big to fail?
Compound Finance has $11B in Total Value Locked while other Defi lending protocols such as Maker come close to $18B in Total Value Locked as of November 16, 2021.
It is not unreasonable to expect that, left unchecked, one of the top protocols backed by the largest VC firms will eventually come close to the amount LTCM managed when they collapsed. The Fed seems to be very worried about the fact that the Tether stable coin has $75 billion tied up in its crypto-version of a money market fund as of November 14, 2021.
SEC Commissioner Caroline Crenshaw published remarks on this topic just this week in The International Journal of Blockchain Law. She highlighted the fact that many regulators had some jurisdictional authority over DeFi, but that DeFi investors were not protected by the same level of compliance and disclosure as other financial markets participants because of the scattershot, inconsistent nature of this regulatory coverage.
For example, a variety of DeFi participants, activities, and assets fall within the SEC’s jurisdiction as they involve securities and securities-related conduct. But no DeFi participants within the SEC’s jurisdiction have registered with us, though we continue to encourage participants in DeFi to engage with the staff. If investment opportunities are offered completely outside of regulatory oversight, investors and other market participants must understand that these markets are riskier than traditional markets where participants generally play by the same set of rules.
Clearly, financial system regulators have their eyes set on DeFi protocols and how they are managing investor money.
The graph below illustrates dates over the last month where the deposits for Compound Finance are less than withdrawals and portrays a low loan repayment volume. Compound Finance can suffer a severe liquidity issue if enough depositors withdraw their funds all at once and the protocols’ asset-liability match is skewed by low performing loans. This suggests a growing imbalance between deposits, withdrawals, and other debits that only requires the wrong kind of match to light a financial powder keg.
If the Bid-Ask Spread is high or relatively volatile it is considered a gauge on the liquidity of a token in the market place. In the graph below it is easy to see that there are large shifts in price change which also suggests a high spread between Bid – Price on the Coinbase exchange for a one day period. Compound Finance is found on multiple exchanges and the Bid-Ask Spread can vary significantly depending on the exchange. That also suggests a potentially manipulable market that more sophisticated players will take advantage of via arbitrage trades.
A quote from Business Insider about the SEC’s enforcement action against a Bitconnect promoter Ponzi scheme seems applicable to any decentralized exchange:
A simple pyramid structure asked users to invest some money, refer and sign-up more users to create a vast pool. The scheme works as long as newer people join and pour in fresh capital. The moment the outflow of the fund exceeds the inflow, the plan fails. If you exit the scheme on time, you’re safe. But if you’re holding the asset when the structure collapses, there’s little hope of recovery, as we’ve seen with a plethora of other similar scams.
Does this scenario describe multiple DeFi protocols in 2021?
There are several times this year where outflows on Compound exceeded inflows.
How long can they provide these returns?
The biggest takeaway is that crypto asset users must be aware and inform themselves of how protocols operate and who is backing them from a managerial and investment perspective. Protocols such as Compound, Uniswap, and Curve engage users on their platform with automated market makers attempting to replace order books. Human market makers that serve as broker-dealers are supposed to maintain minimum capital and keep customer accounts segregated from their own house accounts. Would these exchanges pass capital adequacy, customer funds segregation, and custody audits?
Compound and several other DeFi protocols have reported relatively high annualized returns over a short time period. The annualized returns below are based on returns a trader would obtain if they had a futures contract expiring in a year. The 7-day Average Change is 32.7% while 7-day weighted average is 21.9%. Stablecoins such as DAI, Tether, USD tend to have a higher annual return than other coins.
The graph below shows above average sustained annualized returns for this economic environment. Investors should be extremely careful when anyone offers relatively high returns in exchange for taking on nearly unlimited risk and living with minimal liquidity safeguards.
There is no accusation of wrongdoing by Compound. However, the past may be a good indicator of the future. High returns with extraordinary liquidity risk are red flags for failure or even Ponzi schemes. There are several DeFi protocols with the high returns/high liquidity risk business model. Sushi, Pearl, Aave, and IronFinance all had offers of high returns combined with significant liquidity stress. It’s obvious the DeFi space is ripe for schemes that exploit “irrationally exuberant” investors.
© Francine McKenna, The Digging Company LLC, 2021