Collateral damage: DeFi’s ticking time bomb

The top DeFi lineup is dominated by synthetic asset platforms (SAPs) as 2021 draws near. Any platform that allows users to create synthetics is an SAP. These are derivatives whose value can be compared to assets in real-time. Synthetics can be used to represent any asset around the globe and take on their price as long as there is a reliable price feed.

SAPs bridge the gap between legacy finance and emerging DeFi platforms. They allow investors to place bets on any asset from anywhere and all from the comfort of their preferred blockchain ecosystem. SAPs, which are decentralized and operate on Ethereum’s layer 1, would be crypto’s next major growth driver. But, unlike sound money and verifiable art, the world of collateralized loans is only half the equation.

Collateralized debt

Instruments of collateralized debt, which have a total value of almost $1 trillion, are a prominent part of traditional finance. They are commonly known as mortgages. Their etymology dates back to 13th-century France. It literally means “death promise” in English. However, to those millions of people who suffered the financial crisis that hit 2008, the terms “death guarantee” and “collateral harm” are appropriate.

The gut-wrenching part: In order to receive a loan, a borrower must provide collateral. Creditors may contractually lock the collateral and can seize it in the event that the debtor is unable or unwilling to pay the debt. Servicing collateralized debt is more complicated than simply making timely interest payments. The collateral’s value can fluctuate in response to market volatility, such as the collapse of the U.S. Subprime Housing sector. The creditor, whether a bulge bracket bank or decentralized protocol, can take possession of collateral and sell it at market value to recover the principal. You might call it the rug pull.

Related: The US debt ceiling crisis: A catalyst to crypto’s ultimate decoupling

The risks associated with collateralized financial products can’t be decentralized, regardless of whether they are issued on Wall Street or on the Ethereum blockchain. Fundamentally, liquidation triggers are rooted in the vulnerability to volatility in a wider macroeconomic environment that neither developers nor financiers have control over.

MakerDAO’s lessons for the DeFi space

MakerDAO is an example of a highly decentralized SAP that has its collateralized stablecoin DAI tied to the U.S. dollars. Maker presented investors with an attractive opportunity to stake their crypto holdings in order to create a synthetic dollar. Despite being stable, DAI is supported by a distributed collateral pool, which includes Ether (ETH), and Bitcoin (BTC).

To prevent crypto market downturns from triggering mass liquidations, the Maker protocol requires over-collateralization to the tune of 150%. This means that users receive only two-thirds for the amount they put into the protocol in dollars terms. This model is not appealing to traders and does not support adequate capital efficiency within the ecosystem. To make matters worse, Maker’s high collateral requirements proved insufficient in March 2020 when a 70% drawdown rendered Maker users across the board unable to repay their investments. The result was losses of over $6 million.

Prominent SAPs have learned from Maker’s mistakes and taken extra measures to avoid catastrophic mass liquidations. They’ve actually taken more of the exact same measures: Synthetix requires a bold 500% user contribution, while Mirror Protocol requires collateralization levels up to 250%. Of course, over-collateralization of this magnitude is hardly sufficient to compete with traditional finance, where centralized brokerages provide better metrics hand-over-fist. There’s another problem.

For crypto traders who find exorbitant liquidation and collateralization requirements unpalatable, it is more sensible to abandon SAPs and instead purchase synthetic stocks and commodities on secondary markets. Due to the shift in demand, large pricing premiums persist for many synthetics. This erodes the real-world parity they were meant to maintain and pushes users back to traditional finance where they can buy the assets they desire less brazen crypto markup.

Change is necessary

DeFi is at a halt and has reached a plateau. A radical tokenomic model of collateral management is necessary for meaningful progress. It must redefine the relationship between capital efficiency, risk exposure and capital efficiency. Albert Einstein, the brilliant and articulate man who coined the phrase “Capital Efficiency and Risk Exposure” nearly 100 years ago.

“No problem can ever be solved if you think at the same level as those who created it.”

This agreement states that SAPs are currently focused on improving and enhancing collateralization model — or optimizing what is already in place. None of them dares to venture into the realms of radical transformation.

DeFi will be dominated by a novel collateralization model as 2022 begins and crypto enters a new decade. Instead of locking collateral in a contract, users can burn collateral to create synthetics at an equal ratio. This means that users will be able to burn collateral to make synthetics at an even ratio, dollar-for–dollar and sat–for–sat. Users get out what they put into — and they won’t get liquidated.

A native token with an elastic supply is the key component that supports such a model. It is not possible to perceive any benefit when a user burns an SAP native token to make synthetics. However, when the same user uses synthetics to re-mine native tokens on their way out, SAP’s burn-and–mint protocol is activated. The protocol will take care of any deviations between the original collateral burned and the minted synthetics. It marginally increases or contracts the supply to make up the difference.

The burn-and-mint collateral model is a radical new paradigm. It eliminates the disadvantages of liquidations, margin calls, and reduces the capital efficiency and price parity that give synthetics power. As number crunchers and degens of all faiths continue to search for yields, the capital of crypto mass markets will move to platforms that use various versions of burn-and mint mechanisms in the coming year.

All eyes will be on liquidity management as the DeFi landscape undergoes its next major transition. The key component that allows SAPs to facilitate large volume exits from their ecosystems while avoiding unacceptable volatility is deep liquidity. DeFi platforms have had collateral management issues in the past. Liquidity management will make it possible for DeFi to distinguish the next generation of blue-chip SAPs and those who do not.

This article is not intended to provide investment advice. Every trade and investment involves risk. Readers should do their research before making any decision.
These views, thoughts, and opinions are solely the author’s and do not necessarily reflect the views or opinions of Cointelegraph.
Alex Shipp is a professional strategist and writer in the digital asset sector. He has a background in traditional economics and finance as well as in emerging fields like tokenomics, digital assets, decentralized system architecture, and blockchain. Alex is a professional in the digital asset sector since 2017. He currently works as a strategist at Offshift and as an editor, strategist, and writer for the Elastos Foundation.

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Eileen Wilson

Eileen Wilson –Technology and Energy My Name is Eileen Wilson with more than 5 years of experience in the Stock market industry, I am energetic about Technology news, started my career as an author then, later climbing my way up towards success into senior positions. I can consider myself as the backbone behind the success and growth of with a dream to expand the reach out of the industry on a global scale. I am also a contributor and an editor of the Technology and Energy category. I experienced a critical analysis of companies and extracted the most noteworthy information for our vibrant investor network.

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