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By Amanda Liu
The market volatility that followed the onset of Covid-19 in March provided an unscheduled test for Decentralized Finance (DeFi). This open finance movement aspires to make all financial products and services available to anyone who has an Internet connection and smartphone.
Given that the blockchain’s roots lie in the chaos following the Global Financial Crisis (GFC) of 2008, such a test is valuable in gauging whether new technologies live up to its hype, offering an improvement over existing traditional financial markets.
But as always, the answer isn’t simple. Markets are complex, behaviors are often irrational, and consequences, frequently unforeseen. The trends that emerged during mid-March reveal useful insights into how markets and participants react during a time of extreme stress. Looking ahead to a post-Covid economy of low-interest rates and Quantitative Easing (a government’s monetary policies that serve to inject money into the economy as a way to increase activity), what advantages do DeFi offer?
Taking the U.S. equity markets’ response as a proxy for global financial market sentiment, equities suffered a massive sell-off on March 16, with the Dow Jones Industrial Average dropping nearly 3,000 points–its worst day since 1987’s ‘Black Monday.’ Circuit-breakers introduced following the catastrophic 22% fall on Black Monday came into play on March 9, 12, and 16 as the S&P 500’s opening fell 7% from the previous close.
While asset values have started to recover on news of successive government support packages, echoing the Quantitative Easing measures post-2008, markets have remained jumpy with volatility resulting from any bad news.
For many crypto products, price volatility echoed that of the established markets, indicating that crypto assets are not regarded as a store of value and a haven in times of stress. But decentralized exchanges were able to process record levels of transactions with no downtime: Uniswap (a fully decentralized protocol for automated liquidity provision on Ethereum) handled US$42 million on March 12–nearly six times its average daily volume.
Although the initial phases of disruption on March 12 and 13 saw trading fees spike as traders sought to buy stablecoins (a cryptocurrency that can be pegged to another a crypto, fiat money, or to exchange-traded commodities) or to cash out of crypto altogether, this rise was short-lived, lasting just two days before normal levels resumed.
The increasing uptake of DeFi protocols meant activity reached record levels on March 13, with many users leveraging the power of DeFi to work with multiple systems as they switched strategy from longer-term lending to accessing stablecoins through decentralized exchanges. Overall, although the scale compared to that of traditional markets was massive, participants are in broad agreement that the crypto markets functioned as they should have.
However, one case did receive attention as a possible glitch in the system: Maker’s Dai stablecoin. Pegged to the U.S. dollar, Dai was subject to high demand, as traders looked to borrow. Most had been engaged in lending their coins for the opportunity to gain interest and needed access to Dai to keep their loans afloat. This heightened demand led to a lack of liquidity, which caused price updating to stall, creating an unequal distribution of Dai for borrowers.
Concurrently, this crunch happened as gas fees spiked while the value of Ethereum (ETH) fell. ETH was the collateral for many Dai loans, but couldn’t be auctioned off to liquidate the loans. As many lenders couldn’t liquidate, the stalled process created an opportunity for some liquidators to front-run the ETH auctions with bogus bids, costing Maker US$4.5 million in ETH.
Commentators have interpreted the implications of this situation in differing ways. Some have pointed out that circuit-breakers, such as those that halted the equity markets, would have prevented the shut-down and subsequent inequitable result of the loan liquidations and vulnerability that cost Maker several million. Others have suggested that a more robust price-discovery mechanism that can withstand high volumes and rapid fluctuations should have been introduced.
One thing is clear: unlike the months of uncertainty during the GFC in 2008, where ownership and valuations of countless mortgage-linked products could not be established, transparency of on-chain transactions is superior. Although Dai experienced technical trouble, the reasons for this were evident immediately to all participants, and action could be taken swiftly to rectify the issue.
Similarly, the ability of DeFi protocols to enable very efficient aggregation of on-chain liquidity sources gave participants choices when it came to switching strategies and securing the assets they wanted. The system worked as its developers and founders intended that it should in the wake of 2008.
It’s early in the evolution of DeFi. We are still at the beginning, and much still needs to happen to address the current limitations of these markets. DeFi systems are small and immature, and–as we have stated–scale will help improve some issues.
But the current situation illustrates what is already known about DeFi: it is transparent, robust, and flexible. It provides access and options where other markets may not, and we will continue to learn as the world of low-interest rates and Quantitative Easing unravels in the post-Covid world.
About the Author
Amanda Liu is the General Manager of the OAX Foundation, responsible for building the team and driving the company’s overall strategy and direction. Amanda has over 20 years of experience in the banking industry, holding senior positions at global banks including ANZ, BNP Paribas, and Commerzbank.