How the new crypto cycle begins

“History doesn’t repeat itself, but It often rhymes” — Mark Twain.

To fully understand what is currently happening with crypto and Defi specifically I suggest glancing at my previous essay “Ponzi as natural step in money markets development”. Just to give you a short version, in December 2019 I had a theory that crypto will have its new exponential cycle based on growth through debt and complicate the whole scheme under the complex derivatives on that debt. Why? Because historically when people explore new ways to exchange value, eg. creating equity and debt markets they began to exploit the system to make a profit while everything is going up. And the best way for markets to continue to go up is through debt. The main recipe for such growth is complex mechanisms where most of the people don’t see how bad debt penetrating every corner of the newly developed financial system and bringing more risk.

It is infinitely encouraging to witness the story unravel in front of your eyes in ways you couldn’t predict fully, in ways that are even more complicated and fascinating.

First of all, in just 4 months crypto community finally understood that the best way for tokens to capture value is to not reinvent the wheel and make them behave as equity — generate cash-flow from protocol and give it to token holders (I talked about it here). To get this token though you need to use the protocol, provide some value to it (the idea is great, give a token to actual users and not speculators). In the case of Compound, you give liquidity to the protocol, for instance, by providing a loan to someone or in case of UMA protocol taking one side of a trade (eg. shorting the price of Compound’s token). Another example of such liquidity mining (or yield farming) is currently one of the most popular ways to earn interest on Dai stablecoin through Curve.finance and at the same time get CRV token. Let’s focus at the beginning on the Curve example and how it leads to more debt in the system.

Currently, a popular way to provide liquidity to Curve protocol is through yearn.finance, a service that automates complicated strategies for yield farming. A simplified scheme of what is happening under the hood is below:

• You take your ETH to yearn.finance vault called yETH.
• After deposit, Yearn finance automatically takes it to Maker DAO and borrowing DAI with your ETH as collateral (ensuring 200% collateral ration in the case ETH price goes down)
• As yETH vault has borrowed DAI it deposits it in yDai vault and gives this liquidity to Curve Finance Y pool.
• Now your yDAI providing liquidity to Curve, generating fees for you and mining CRV token. (Curve needs your Dai to ensure liquidity for people who trade between different stablecoins).
• Automatically your newly received CRV token will be sold for ETH which then again will follow the same cycle from step 1.

As you can see above, this scheme of liquidity mining creates buying pressure for ETH, then ETH leveraged up to mine CRV, which is sold to get more ETH, and mine more CRV. It’s close to what I described in December here, but this is the simplest liquidity mining scheme with not as many risks.

Obviously liquidity mining is happening not only with ETH or DAI, it is happening primarily with other assets and in the process inflates their prices as well. But, things become more interesting with liquidity provider tokens (LP token) that you get in exchange for the asset you provided to the protocol. Let’s see an example with providing sUSD to Curve which is a synthetic stable coin that is debt in itself (the same as DAI) created with SNX token. When you are providing sUSD you will get in exchange the LP token called sUSDv2. But what if I tell you that you can mine a bunch of others awesome token with sUSDv2? Practically with the same amount of collateral miners can earn several different tokens. Such liquidity mining scheme with the reusability of collateral is happening all over the place, which leads to even more buying pressure for tokens which are used to get LP tokens in the first place.

If the scheme above was complicated to grasp for many, from here things began to grow exponentially more complex as you began to explore more liquidity mining strategies. Because to get liquidity in the first place liquidity providers can use lending platforms as AAVE to take debt based on other liquidity provider tokens that they might have from providing liquidity to Uniswap pools and the list goes on and on. I was looking at ways how the most lucrative liquidity mining schemes already generating profits and most of them are basically highly leveraged positions on bad collateral as LP tokens which are used in several places simultaneously.

So why all these protocols even do that? The answer is Total Value Locked or TVL, it’s the simplest metric to judge protocol success in Defi, as the higher TVL protocol has, the more fees protocol will be able to amass and share with token holders, therefore its market capitalization should go higher. The prices of token rise, liquidity provider can get more debt for less collateral and mine more new hot tokens, and the cycle repeats.

The most dangerous thing now you don’t need to participate in liquidity mining to be exposed to underling risks, in just 2 months it’s already spread like fire everywhere in the Ethereum ecosystem. The next stage already began with more Yearn finance Vaults, while I strongly believe the founder has a good intent by providing automated schemes for liquidity mining, it will take just a few weeks before opportunistic platforms will hook up to yearn finance and make it incredibly easy for the average person to earn perceived 500% and more interest without understanding any risks of the underlying mechanisms. My worries here is that simple Ponzis as Bitconnect and OneCoin are what the average person can’t resist, the combination of crypto and high returns just clicks for retail investors. New schemes with high return justified by the complexity that retail can’t understand is an explosive product for scammers.

That’s how I believe the craziest part of this cycle will begin. It was hard for outsiders to understand what is happening in 2017 crypto, it will be impossible for the average person to understand crypto 2020–2021. How can we prevent this explosive growth through leveraged debt and following the bust of the bubble? I don’t think we can at this point, greed is too big, systems are too complex. The best thing we can do is to disclose as much as we can about risks and educate people.

The next frontier is to make insurance products work. Interestingly, insurance is usually playing a huge role in economic bubbles, I believe it will also have a sizable part in the growth of Defi by adding to the complexity of the market and ROI generating strategies for DAO funds. But the role of insurance in Defi will be a theme for the next essay.