The Decentralised Finance (DeFi) market has experienced spectacular growth since the summer of 2020 (referred to as ‘the DeFi summer’), when a number of DeFi applications appeared to gain traction with users. The total value of crypto-assets locked in DeFi applications built on the Ethereum blockchain peaked in November 2021, exceeding USD 110 bn – a more than 50-fold increase in a year, albeit from a low base. And this does not account for an increasing number of applications built on alternative blockchains, other than the Ethereum one. Investors joined this market for fear of missing out, driven by speculation and in search for yield in an –until recently- ultra-low rate environment.
The ‘DeFi summer’ has now given way to the ‘crypto winter’: A recent crypto-asset sell-off that started in November 2021 has intensified in the past few weeks amid a broader correction in risk assets, such as growth equities and technology stocks, and perhaps driven by an environment of higher real yields and the foreseen tightening of monetary policy. Although crypto-assets can hardly be considered a good hedge for inflation, OECD analysis shows that Bitcoin (and to a lesser extent Ether) was perceived by a large part of the investor community as such and the last crypto rally in the second half of 2021 coincided with increased inflation expectations. Since then, the main crypto-assets have lost more than a third of their combined market capitalisation (corresponding to about USD 1 trillion).
Corrections in markets for crypto-assets are not new and we have already experienced many cycles of exuberance followed by corrections. Although frequent, such corrections are becoming an increasing concern for financial market participants and policy makers, for two main reasons.
First, the use of mainstream crypto as collateral in DeFi lending protocols and the margin call mechanisms that automatically liquidate such collateral when their price drops. The volatility of crypto-asset prices intensifies the fragility of the DeFi market, and volatility spikes in the price of main crypto-assets, coupled with increased use of leverage, can induce massive automatic liquidations in DeFi protocols. On top of these automatic collateral liquidations, crypto-asset futures liquidations – particularly on crypto exchanges – intensify market stress.
Such liquidations can have a domino effect on investor holdings across the board, and may even have spill-over effects in traditional markets given increasing interconnectedness between decentralised and traditional finance and growing institutional investor participation in digital asset markets.
This brings us to the second reason for concern: Investors exposed to losses in DeFi may also have to close positions in traditional markets, propagating the shock. The role and weight of stablecoins as the main facilitator of such interconnectedness, and the underlying weaknesses of major stablecoins (Tether’s USDT, Circle’s USDC) constitute one of the most important potential channels of risk transmission to traditional financial markets.
The use of major stablecoin arrangements as collateral or as the bridge between DeFi and traditional finance constitute one of the greatest points of vulnerability of the DeFi market: In a scenario where a major stablecoin ‘breaks the buck’ and loses its peg due to solvency issues related to the reserves backing the stablecoin or its under-collateralisation, decentralised exchanges would go under severe stress and liquidity pools would be further forced to mass liquidations. Such risks are exacerbated due to limited trustworthiness associated with the auditability and reporting around their reserves, as well as with the composition of such reserves and stability of the custodian of such reserves.
Tether, the issuer of USDT, has been charged for making untrue or misleading statements and omissions of material fact relative to the reserves backing the stablecoin. In addition to market concentration concerns (with USDT accounting for more than 50% of the market), stablecoins are reportedly increasingly investing in commercial paper as part of their reserves backing the crypto-asset issued and rank among the largest holders of such instruments globally. Any sudden risk aversion to such stablecoins with significant holdings of such short-term debt instruments could disrupt CP and other short-term debt markets.
The recent crypto-asset market turmoil saw USD 295m of crypto-asset collateral liquidated only over the past 7 days by the top three DeFi lending protocols (Aave, Maker and Compound), according to Dune Analytics (as of 27 January 2022), and could further intensify if the crypto-asset sell-off continues. MakerDAO liquidated USD 119m of collateral on 21 January 2022, stating that over USD 600m in ETH was in danger of liquidation at the time, and Aave recorded USD 61m of collateral liquidations the day after. In addition, over the same period, over USD 1.3bn in long liquidations of 500,000 futures contracts occurred in decentralised exchanges.
Mass liquidations during crypto-asset sell-offs test the limits of the DeFi protocols under stress. Until today, the high levels of collateralisation involved in lending protocols have allowed DeFi to withstand such pressures, although at the cost of financial consumers who incurred important capital losses and high transaction costs. For example, similar liquidations were observed during the ‘Black Thursday’ event (12 March 2020), which constituted the first noteworthy stress-test event in DeFi’s short history, when Ethereum dropped by more than 20% in a day. Such drop caused waves of automated liquidations, while users trying to shift their crypto from one application to another led to a raise in ETH gas fees to 200 Gwei, crowding out small-value transactions that became uneconomical to execute.
As decentralised finance markets have evolved rapidly, so have policy discussions. The OECD Committee on Financial Markets and its Experts Group on Finance and Digitalisation delved into DeFi in early 2021, looking into risks emerging from DeFi activity and how policy action could address these. The Committee’s focus now is on the increasing interconnectedness between decentralised and traditional markets, and the potential financial stability risks related to the crypto-asset markets. Such interconnectedness is expected to grow through the introduction of tokenised assets as collateral in DeFi protocols, in the place of mainstream crypto-assets or stablecoins, allowing traditional financial institutions to unlock liquidity and obtain leverage on pre-existing assets though DeFi.
Policy makers certainly need to closely monitor this market and better understand its mechanics, potential benefits and underlying risks. As the list of risks for investors and financial consumers in DeFi is very long, users should be made aware of these risks. In addition to exploring ways to enforce existing rules in decentralised structures with no single regulatory/supervisory access point, policy makers could consider exploring potential regulatory gaps for new types of risks that arise in DeFi systems; these may stem from the novel characteristics of financial service provision in decentralised systems, and could give rise to regulatory arbitrage opportunities. Some of the regulatory tools applicable in centralised settings may need to be redesigned to be made interoperable and compatible with decentralised structures.
In addition to exploring ways to enforce existing rules in decentralised structures or consider new rules, policy makers could consider exploring lessons drawn from DeFi for the use of DLTs and decentralised structures in traditional finance. While DeFi could end up being a short-lived phenomenon, deeper consideration of what value decentralised finance services could bring to users, the financial system and the real economy would be beneficial to all. For example, there is growing evidence that the DeFi space is incentivising innovation and inspiring established market infrastructures and players to rethink and improve the efficiency of existing processes, as is happening with post-trade processes and financial intermediation.