DeFi Boom Becomes Dangerous as CDPs Trigger Memories of CDOs
DeFi has become a flagship use case for blockchain technology. By offering asset management, borrowing, lending, and remittance services without intermediary parties, DeFi is moving to shake up the traditional financial services industry. However, the increasing popularization of leverage instruments threatens the health of the market.
Investors in traditional markets still remember the horrors of the 2007 US housing market crash, and the subsequent financial crisis that followed. The debt crisis, as it was also called, was catalyzed by people overleveraging. On the ground, retail investors were caught up in the house-flipping frenzy; people were taking out mortgages that they could not pay off with the hope of flipping them at a profit.
Chart from: finance.yahoo.com
Additionally, the financial industry created derivative instruments, known as collateral debt obligations (CDOs), that were supposed to provide revenue streams based on mortgage payments. Everything worked great while the real estate market was liquid and growing. When the music finally stopped and people could no longer resell these houses and therefore had no means of paying off their mortgages, the real estate market collapsed, taking the CDOs — and the institutions investing in them — with it.
The Makings of a Crypto Credit Bubble
Crypto markets don’t have CDOs, but they do have CDPs, or collateral debt positions. This instrument, popularized by MakerDAO, enables users to take out loans using collateral assets. In the case of MakerDAO, this means leaving ETH in a smart contract as collateral and securing a loan in Sai (formerly Dai) a stable currency.
At face value, this is a great concept. Users can get loans quickly, and the initial value of the collateral is some multiple of the value of the Sai. So, if the market takes a turn for the worse, the collateral can be liquidated to ensure solvency. In the worst-case scenario,…