Fragility in DeFi
This month DeFi markets experienced unprecedented growth as the total value locked in DeFi surged from just under $979 million to $1.57 billion. In other words, the total value locked in DeFi has grown an astonishing +60% in June.
Make no mistake, this parabolic growth in DeFi markets was no coincidence. What spurred this rapid inflow in the DeFi markets was Compound’s launch of its token on June 15th. What makes Compound’s token so special is that not only does it allow holders of the token to participate in Compound’s decentralized governance, but lenders and borrowers on the Compound platform get rewarded a portion of COMP for participating in the network and currently… rewards in COMP are substantial. At the current market rate, the total amount of COMP distributed each day equates to $576,000 — half goes to COMP suppliers and the other half goes to COMP lenders (For More Info). Initially, that may not seem like a lot until you factor in that 4,180,127 COMP tokens will be distributed, which at the current market rate, equates to over $89 million.
Investors have flocked to the Compound platform realizing they can earn a yield on top of their lends and borrows. Lenders get to “double-dip”, while borrowers, in some cases, may even get paid to borrow. As a result, the insane demand to participate in Compound has caused the token price to skyrocket from $78 to $336, or 330%, within its first week of trading. In less than a month’s worth of trading, COMP rose to become the largest DeFi token by market capitalization with a market cap of over $2 billion or 4x Maker Dao’s governance token Maker, which has been around for the last three years.
However, COMP’s token model not only sparked a new wave of DeFi users but sparked a DeFi movement in itself. Interestingly, in DeFi markets you can lend and borrow across platforms and hunt for the largest yield possible. Several DeFi users were earning over 100% APY utilizing compound rewards and other DeFi lending protocols; https://www.forbes.com/sites/leeorshimron/2020/06/22/defi-yield-farmers-and-crypto-investors-are-raking-in-100-annualized-yields/#58ec10315eb5.
In just this month, this DeFi craze garnering extremely high yields on lends across DeFi platforms became known as “yield farming”. Not only are investors now adopting this new investment style, but other DeFi platforms have or are currently looking to adopt a model similar to COMP (for example BZX and Balancer).
However, “yield farming” does not come without risks because at some point every farmer, eventually, experiences a drought, which could potentially turn into a devastating blaze.
We have already seen the cracks in the foundation take place as DeFi protocol Balancer was hacked twice in a matter of 24 hours. This sent the market a reminder that the reason why yields are so high is to compensate DeFi users for their inherent risks (immature technological infrastructure) that comes along with investing in DeFi. With over $550 million of total value locked in Compound many are sure hackers are at least pondering the thought of some type of Compound attack.
But there is a more palpable risk plaguing the current Compound platform. See, what they don’t tell you about the DeFi platform is once you “enter into the Compound”, ironically, there is no guarantee you will be able to leave the Compound.
Since the inception of COMP rewards, Basic Attention Token (BAT) had initially become the most utilized token to lend and borrow. Just last week, $324 million worth of BAT was being supplied and $294 million worth of BAT was being borrowed. Yield farmers had been attracted to this token because to supply it, BAT yielded an APR of 14% (in BAT). However, in fear that there could be a devastating deleveraging if BAT borrowers were to unwind their positions, as more than 70% of BAT was sitting on Compound, Compound justly changed the way they distributed their rewards. Although this event allowed BAT holders to safely deleverage their holdings, systemic risk of a massive deleveraging unwind was not eradicated but transferred causing a larger systemic risk on Compound to fester.
Since Compound changed its rewards distribution mechanism, Dai is now the most popular cryptocurrency to supply and lend on Compound with over $600 million worth of Dai being supplied and over $500 million worth of Dai being borrowed. What’s formidable about the +$1billion worth of Dai sitting on Compound is that as opposed to BAT which had +70% of all BAT being held on Compound, there is 5x more Dai being held on Compound than there is Dai in the world (Coinmarketcap estimates Dai has a market cap of $178 million), but what does this mean in terms of risk?
On Compound, to borrow a token such as Dai, you need to put another token up as collateral and outside of Dai, the two most popular tokens used as collateral are USDC with a supply of $420 million worth and ETH with a supply of $243 million worth. In other words, all Dai borrowers are posting the majority of their collateral in USDC and ETH. Now the minimum collateral needed to borrow on Compound is 133% which means you need $1.33 worth of ETH to borrow $1 worth of Dai. So, unfortunately, while Dai borrowers are collecting rewards in COMP, they are faced with the risk of their collateral depreciation and their debt appreciating. As an example; if the total value of their collateral to debt falls under $1.33, Dai borrowers will be forced to liquidate. However, because crypto markets are extremely volatile, the problem is what happens if there is a significant surge in either the price of Dai and/or a significant drop in the price of the collateral. This would force a massive deleveraging as Dai borrowers would have to go into the market and buy more Dai to pay down their debt (essentially covering a short position). However, with $500 million worth of Dai being borrowed and $600 million BAT already being supplied, there is not going to be enough liquidity in the marketplace for all these borrowers to cover their debt. Just to give you an idea of how bad this could be, Tesla’s stock had a short interest ratio around 0.30, three shares borrowed for every 10 shares — the shorts were “squeezed” and rallied 5x in early 2020.
Now, Dai has a daily volume of just $7 million and there is $500 million worth of Dai being lent on Compound. Essentially, 71x the amount of Dai’s daily volume holding a synthetic short position. The short covering in Dai could ignite an unprecedented short squeeze. Meanwhile, Dai prices would surge as borrowers go into the market and try to find enough Dai to cover their debt, Compound liquidators would be scooping up Dai, borrower’s collateral, at a discount and selling it in the market putting more pressure on the already widening current collateral to debt ratios reinforcing a wicked feedback loop of liquidations. Yield farmers would essentially see all their gains evaporate. Meanwhile, all these transactions would be putting pressure on the Ethereum blockchain and could facilitate a flaw in Ethereum’s blockchain where an event like the Maker Dao hack could occur. It is important to note that the reverse could also happen, where suppliers of Dai could also be liquidated if there is an event that causes debt to collateral ratios of Dai supplied borrows to also widen.
An event that causes a Dai deleveraging is unlikely to take place. Partially, because Dai is a stablecoin that should hold a 1:1 peg with the dollar causing some stabilization within collateral debt ratios, and partially because Compound could step in again and change the rewards distribution system to try to ameliorate the systemic risk. Nevertheless, the underlying conditions needed to set off this “spark” are present and should not be ignored.
- Edward Puccio, Digital Asset Analyst BKCoin Capital LP