Even if Satoshi Nakamoto created Bitcoin, he may appreciate the world created by Ethereum’s Decentralized Finance (DeFi).
Just as the anger caused by the financial crisis in 2007 gave birth to Bitcoin, a new payment system, DeFi has subverted the traditional banking model of today. DeFi is license-free, programmable, and powerful, and can operate through open source code, open access, and decentralization.
As of today, the value locked in DeFi is close to $ 1 billion. But with the development of DeFi, hacking is also proliferating, causing users to lose millions of dollars worth of funds.
DeFi suffered financial losses due to hacking attacks. Source: DeFi: Dependency Hell Meets Finance 
Although DeFi is very different from traditional finance, it still needs to work hard to solve the three same factors that caused the 2007 financial crisis:
- 1. Yield chase
- 2. Chair grab game
- 3. Super relevance
In physics, it is impossible to get rid of gravity. In the financial sector, it is impossible to escape from the market. So let us delve into these three lessons.
Yield tracking has inherent risks
Yield chasing is one of the earliest causes of the financial crisis. The low interest rate after the dot-com bubble caused investors to chase higher yields in the form of subprime loans.
In the financial sector, the rate of return reflects risk. Today, investors can earn 80 basis points on U.S. Treasury bonds and 6% on high-risk bonds. This difference (the latter has a higher yield) is to compensate for the risk that high-risk bonds may not be able to repay the principal.
The challenge for investors is to determine which rate of return is an opportunity and which rate of return is high due to the high risk of the financial product itself.
A core mistake of the 2007 financial crisis was the erroneous assessment of the risk of high-yield securities backed by mortgages. Subprime loans—even AAA grades—are never impeccable, although rating agencies and mortgage originators do not think so. [Remarks: Subprime mortgages refer to loans provided by some lenders to borrowers with poor creditworthiness and low income, the most important is housing loans, and the interest rate of subprime loans is usually higher]
DeFi also encountered the same problem. Users compare the benefits of different DeFi protocols without paying attention to potential risks:
The actual risk-adjusted return on capital (return divided by risk) is driven by factors that any retail investor needs to spend a lot of time studying, such as these factors:
- Security risk
- 1. Mortgage rate
- 2. Governance process
- 3. Liquidation process
- 4. Network availability
If retail investors fail to notice all of this information, they may make high-risk choices and miss opportunities that have lower returns but are much more reliable.
Unlike ICO (Initial Token Issuance), although DeFi is very risky, most DeFi projects have limited benefits. A “first prize” ICO may bring a 5000% return, and the potential loss is up to 100%; but for decentralized lending, the best case is that the return rate is between 10% -20%, If the DeFi protocol is attacked, the loss rate is as high as 100%.
Everyone is playing a chair grab game
For banks and DeFi agreements, chasing yields leads to a vicious circle, but this does not stop everyone from playing the game.
As Chuck Prince, former CEO of Citigroup, said at the beginning of the financial crisis in 2007:
“In terms of mobility, if the music stops, things get complicated. But as long as the music doesn’t stop, you have to stand up and dance.”
In essence, those organizations that carefully manage risks will experience losses until they win. The market is a vicious circle, which means that well-thought-out CEOs will not be rewarded until the market crashes and maximizes their risk when competitors crowd out of the market. As Warren Buffett said: “Only when the tide recedes will you find out who is swimming naked.”
The same effect also occurs on DeFi. For example, to beat the loan interest rate of the Compound agreement, a simple method is to require a lower mortgage rate and make the mortgage rate close to 100%. Lower mortgage rates make these loans more attractive to borrowers (because low mortgage rates mean that borrowers need to mortgage fewer assets), increasing the yield they are willing to give to depositors (lenders). In a world where profitability is chasing, this competitive product can quickly gain market share-just like Chuck Prince’s Citigroup-although the risks are much greater.
As competition leads to lower guarantee standards, higher profits, and increased risk for each DeFi agreement, a vicious circle will follow. Thoughtful agreements can try to increase the mortgage rate, but to do this, they must provide a lower rate of return. Then users will turn to less well-thought-out competitors, if they want to compete for users, they will force all agreements to lower the standard.
This is the typical prisoner’s dilemma:
DeFi faces such a prisoner’s dilemma
Risk scoring — Wall Street rating agencies such as DeFi Score and other DeFi rating items — can play a role, but their voices are often overlooked.
In the field of DeFi, in fact, only when users lose money and start to take these risk factors seriously, the risk rating will be valued.
Everything is connected to each other
During the financial crisis, no bank was isolated. Today, no DeFi agreement is an island.
The mistakes of Lehman and Merrill Lynch caused problems for the best operating banks. No matter how smart Goldman Sachs is in risk management, it requires AIG (American International Group) to pay for policy fees:
The chart above shows that during the 2007 financial crisis, “the billions of dollars used by the government to rescue AIG and the billions of dollars used by the Federal Reserve to clear the company’s worst credit default swaps, of which nearly $ 40 billion was transferred to Only 10 financial institutions that are the counterparties of the company ’s transaction have been acquired. ”These 10 financial institutions include Societe Generale and Goldman Sachs. Source: New York Times
In the final analysis, finance is an intertwined house of cards:
As of June 2008, Goldman Sachs’ top derivatives trading counterparty, source: Financial Crisis Investigation Committee
In the field of DeFi, various DeFi protocols are similarly connected to each other. Compound relies on multi-mortgage DAI smart contracts; PoolTogether relies on the operation of both Compound and multi-mortgage DAI … as Coinbase engineer Daniel Que pointed out:
Due to composability, the DeFi protocol can also become a house of cards.
For example, in the recent attack on the bZx protocol , the dependence on the Kyber oracle led to a surge in the price of Synthetix USD (sUSD), which caused bZx to suffer losses. In another incident, hackers exploited the re-entry attack vulnerability in imBTC (an ERC777 token), causing the Lendf.me protocol to be stolen by $ 25 million. The hacker created a false balance and used it to borrow funds.
Composability is one of DeFi’s superpowers, but it is also one of its greatest dangers. Just as in the financial crisis, even the best-run banks are not safe, rigorously audited smart contracts are not immune to interaction with all other protocols and primitives, especially those that were not deployed when their original code was deployed Constructed protocols and primitives.
Never forget-finance is finance
DeFi is still in its infancy, and it is still a long time before it becomes the foundation of the next financial system. But if it is to become the basis of financial operations, it needs to become anti-fragile.
DeFi protocol scoring items like DeFi Score can educate users about risk. The DeFi protocol can write test suites to test common dependency bugs. The protocol can be constructed in a way that is resilient to unexpected failures. DeFi itself can provide insurance through agreements like Opyn.
After all, DeFi is not a banking industry. It is open, license-free, and programmable. But finance is finance, regardless of the technology stack underneath it.