At the Terminator Robots Police Loan Markets

Suspension

Nine days after Avraham Eisenberg started borrowing cryptocurrency tokens from Aave Curve, a decentralized digital asset lending platform, he found his $38 million(1) loan suddenly liquidated by termination bots.

Losing $10 million on a kick-off seems rather disturbing, compared to everything else going on in Eisenberg’s life — a self-described “applied game theorist” was recently arrested in Puerto Rico for allegedly draining $110 million from trading platform Mango Markets. However, the launch of a trader’s short CRV position, as curve tokens are known, sparked lively controversy.

The sudden shrinking lifetime of a loan is a feature of decentralized finance, or DeFi, the marketplaces that allow volatile cryptocurrencies to be loaned against one another. The merchant borrowed CRV tokens by publishing USDC, a dollar stablecoin, as collateral.

If this is a conventional debt, the borrower will get a margin call when the lender becomes uncomfortable with the collateral covering it. On a public blockchain, anyone can track such situations. To keep the system secure, auditors are encouraged to intervene. These are algorithms that collect what is called a quick loan (more on that later) to filter out vulnerable short positions. They get a reward from the software token – the smart contract – running lending protocols like Aave.

Although not directly related to the Eisenberg loan, recent work by academic researchers has concluded that DeFi contains systemic fragility, where one liquidation triggers another liquidation. Collateral prices are affected across trading venues; The malaise spreads. Flash loans are to blame — they are so fast and frictionless that decentralized lending is inherently avalanche-prone.

At the opposite end are practitioners who believe teething problems are normal for an emerging industry. DeFi deserves a fair chance to create a cheaper alternative to traditional broker-driven finance, or TradFi, which — for all the progress it’s made since the advent of gold bankers in the 17th century — still relies on expensive taxpayer-funded bailouts. Remember the mortgage crisis?

In the case of Eisenberg, there is nothing striking about his loss. What’s problematic is that Aave, the platform, was left to pay off $1.6 million worth of bad debt after algorithms – taking advantage of a 75% increase in CRV on November 22 – closed the short position. At first glance, this seems to be a point in favor of the fragility hypothesis developed by University of Calgary economist Alfred Lehar and Christine A. Parlor, professor of finance at the University of California, Berkeley. According to them, the fundamental difference between DeFi and TradFi is that the former does not place any capital restrictions on arbitrage. Is that a problem? Well, it could be.

Anonymous DeFi borrowing and lending. In the absence of a credit rating, recourse or reputation of the borrower, loans should always be well below collateral, especially because the currency being borrowed and the currency against which it is being borrowed can fluctuate greatly. To keep the lending pool safe, algorithms scan digital platforms for loan-for-value standards violations. When not engaging in shaky debt—Eisenberg’s position exceeded the maximum allowed by the system of 0.89 on November 22—they were programmed to take out a quick loan, use the proceeds to close off part of the original debt, extract the collateral and sell it to eliminate their liability.

Unlike traditional finance, these four things happen in one block of validated information. Either the transaction takes place in its entirety and is reflected by all copies of the distributed ledger, or it is not reflected at all. Which is why bots don’t need to bring in capital to pocket the promised liquidation incentive – 4.5% in the Eisenberg loop. They pose no credit risk to the lenders who provide the money to carry out the killing. Lehar and Parlor note that “experience is more likely to be the credit than the capital because of the presence of quick loans”.

These are full marks for capital efficiency. But we must also calculate the cost of the frictionless lending system. And therein lies the crux of the “Where’s DeFi” debate: Did Aave’s bad debt result from a fatal, unsolvable flaw, or did a design tweak prevent it?

In a paper covering the episode, a group of blockchain professionals has come up with a possible answer. Beyond the threshold, the November 22nd liquidations become toxic. Each forced closing of his loan made Eisenberg’s remaining position riskier when compared to the available collateral. That, in turn, called another bot, and everything got out of hand. If the fixed liquidation incentive of 4.5% had been dynamic, if it had decreased gradually as the collateral cap dwindled, the platform could have avoided accumulating any bad debts.

“Toxic liquidations are dangerous for the protocol because they mathematically guarantee that the health of a user’s wallet will deteriorate through no fault of their own,” Jacob Warmuz and colleagues note in the study. “As a general rule, abrupt short-term responses to complex dynamic behaviors produce worse outcomes than the response set out to achieve. They should be avoided unless absolutely necessary.”

Fixes should arrive sooner rather than later. Not because your next mortgage will be DeFi – good luck putting your municipal property registry on the public blockchain. The main impetus is that a large part of the traditional trade in commodities could benefit if decentralized finance allows a fund of wine or Japanese yen owed by its importer to become an asset in the blockchain. so that money may be raised for it more cheaply than would now be possible after fees were paid to the intermediaries. In November, JPMorgan Chase & Co. With a small transaction on Aave, it took its first live position on a public blockchain. With the TradFi giants getting their start in DeFi, the whole thing is getting serious.

Whether the future of DeFi is fantastical or dystopian is not something finance professors or practitioners can determine for themselves. A piece of software that runs like a full contract, leaving no room for the courts to step in if things go wrong, requires us to imagine, among other things, a less healthy ending to Shakespeare’s “The Merchant of Venice.” Legal and cultural philosophers should also bookmark Eisenberg’s filtering. They may have to get into the discussion soon.

More Bloomberg opinion:

• Will cryptocurrency be a safe investment?: Andy Mukherjee

• Beware of the dangers of too much cryptography: Tyler Cowen

• Beware of the crypto billionaires who brag about vetting: Lionel Laurent

(1) See “Toxic Liquidation Snails: Evidence from Bad Debt incurred by AAVE,” paper by Jacob Warmuz, Amit Choudhury, and Daniel Pena.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Andy Mukherjee is a columnist for Bloomberg Opinion covering industrial and financial services companies in Asia. He previously worked for Reuters, Straits Times and Bloomberg News.

More stories like this are available at bloomberg.com/opinion

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