Throughout history, new financial instruments are quite often got exploited at its inception. It happened in the 18th century in England with the proliferation of equity and debt markets, an event known as the South Sea Bubble [1]. The same exploitation happened with the first digital derivatives based on toxic debt when we got the Housing market bubble [2]. And it’s usual for communist states when they transition to capitalism to drown itself in humongous nation-wide Ponzi schemes.[3] When people explore new protocol (centralized or decentralized) to communicate value (money, equity, debt, etc.) after protocol developed and ready for the general public to participate in, the first thing that happens is that opportunistic players come in and create pyramid-like schemes.
Why does it happen? The greed of insiders who can exploit obscure financial mechanisms to attract investments from fools who believe in making money with no effort and easily fall for “new paradigm mentality”? Yes. But also people often got entangled in incentive structures of systems they can’t fully understand. Fundamentally money and money-like instruments have an enormously strong property to concentrate in the hands of a few. Money’s Power Law Distribution [4] is so pronounced because broadly speaking dollars are a proxy for energy itself encapsulated in our legal system. It makes sense to expect a derivative of value to inherit the same property to exponentially concentrate in one place. Unless of course regulatory crackdown happens to stop forces of nature itself and average people from losing their money. But usually at the beginning regulations are too slow to interrupt a multitude of financial pyramids, quite often people close to the government even have an incentive to perpetuate them.
My excurse into the history of legacy finance and its pyramid-like nature is vital for exploration of how crypto-economy has been developing and how it will probably continue to develop. A decade ago a new type of money was created as an elegant way of encapsulating energy in the biggest decentralized protocol of global digital property rights registry called Bitcoin. Bitcoin already went through several boom and bust cycles of pyramid-like nature because strictly speaking people buying in the hope it will go up as more demand follows in the future. Don’t get me wrong, not all pyramids are bad, especially ones that transparent and give people a choice to opt-out from corrupted financial systems. The next thing creating a splash was the ERC20 standard for equity-like assets and ugly creation as ICO mania. Slowly but surely we came to the debt standard as Dai created by Maker DAO. While Dai still isn’t looking as significant, the protocol for debt is a crucial part of any functional economy because it gives a way for the value that has not been created yet to manifest itself here and now.
Simply saying, with debt, money can concentrate even faster in the hands of a few. That’s where I believe crypto on the brink to tap the most powerful positive feedback loop money can find. A vicious cycle of growing money pot through the creation of more debt while obscuring the whole relation between the two behind the complexity of derivative instruments.
Let’s go through a possible scenario of how such mania can start. Step one, opportunistic lending platforms start to promise higher returns (over 30% annually) by reinvesting Dai in DAO controlled funds which trading highly sophisticated for the average user derivatives on debt [5] (e.g. longs on Dai market cap, tokenized insurance against risky CDPs [6] going bust, etc.). Step two, after the first wave of investors pushed the price up by merely buying ETH and converting it to Dai, DAO funds began to make more profits and raising returns for investors. The third step is when more people come and open new risky CDPs to get more Dai and reinvest through lending platforms again. As collateral for Dai as ETH will go up the whole DeFi market will begin to grow exponentially, hence DAO funds will get even more profits and more toxic debt underlying growth will ripple through the system. That’s how a positive feedback loop can begin to suck all the air out of the system and create extreme risks for everyone.
As it was numerous times before the average user will not look at the risks and think that it’s a new money paradigm. Taking into consideration what happened in 2017 and how little understanding the average retail investor had to give money to anyone with a website and a bag of tokens, I have a very bleak picture in front of me. The size of liquidity pools not restricted by any border and no regulations can fuel such pyramid-like structures to huge sizes and even create a real threat for a global economy. Think OneCoin or Bitconnect, but started not as scams, but as high-risk tolerance lending platforms with teams of smart people who were just trying to outcompete others by providing higher returns.
Every big bubble starts with a dream of financial independence and promising, but obscured financial mechanisms of the system. I can not say that next mania will follow these exact steps, however, we are getting closer to every piece to fall in place. And I just hope taking into consideration such outcomes, people who are building out DeFi ecosystem will be able not to lose sight of potential risks and not become blind conduits of incentive structures they are putting in place.
[1] Private investors who held England government debt would get to exchange that debt for the share in South Sea Company. The government would pay South Sea Company around 6% on that debt, significantly lower interest rate than the government had been paying when all the debt was in the hands of private individuals. The company would then turn around and use that money as a dividend for its investors. But in order to make that offer enticing, there had to be something more for private investors. That something was a monopoly on trading in the South Sea. Further, the company’s stock price was pushed higher by luring people to buy stock with the help of engineered loans specifically for that purchase.
[2] By pushing mortgages on borrowers by predatory tactics knowing that they will never be paid off. Then to give that junk debt AAA rating and shovel it in every pocket of the economy.
[3] Ponzi Schemes in Albania and Russia.
[4] Power law
[5] While derivative platforms such as Synthetix and UMA Protocol are quite young and mentioned derivative hasn’t been created yet, it’s just a matter of time when they will be rolled out.
[6] Collateral Debt Position in Maker DAO system is underling Dai stable coin creation. When the price of ETH goes below the certain limit, CDPs should be closed and Dai should be burned in that process. If there are too many risky CDPs that can’t be closed in time, Dai can start a downward spiral and become insolvent.
