Browsing Tag: position closing line

    Logic and law
    DeFi

    Enlightenment from the collapse of encryption market on March 12: what is missing in DeFi?

    June 29, 2020

    The crash of March 12, and many people in the industry lost confidence, especially in the field of DeFi.

    Taking the stable currency project MakerDAO as an example, because of the collapse of 312, the debt position of the mortgage stable currency appeared to be out of position (i.e. insolvent), thus the MKR auction was started.

    In the whole process, various kinds of jokes were flying everywhere. Some said that the assets were captured at 0 cost, some said that the loss was how much, some said that the project was over, some wanted to sue them, and even the foundation felt pressure to hand over the governance to the community.

    Self-Sustaining MakerDAO

    It seems that the entire crypto community is beginning to doubt whether or not DeFi can really be established.

    This kind of doubt leads to collective reflection of the industry. Many people have written articles and summarized 312, with strange phenomena and even more strange explanations. MakerDAO has also made a lot of adjustments, including liquidation, auction and so on. It is becoming more and more complicated, but the purpose is only one, that is, when this situation occurs in the future, it can avoid the recurrence of 312 event. These starting points and original intentions are all good, and they hope that DeFi can have a virtuous cycle, sustainable development, and truly enter the public’s vision. However, these summaries, including the recent adjustment of MakerDAO, always feel that it is better to change the soup without changing the dressing, which does not point to the core of the problem.

    Currently, the well-known DeFi, whether MakerDAO or Compound, is the so-called excess mortgage and limit price closing mode. On the face of it, the excess mortgage and the liquidation of the water mark are impeccable. But these designs, in essence, are options one by one! Since it is an option, it must involve three important variables: price, risk-free rate of return and asset volatility.

    These things are not information on the chain. Because the impact of price variables is too significant, someone has designed a scheme called the Oracle, trying to transfer the required price from the centralized exchange representing price discovery.

    Both MakerDAO and Compound use price prediction machines. Then, the risk-free rate of return and volatility are implied in the pricing formula, which is not easy to detect. Therefore, no matter which DeFi is in the current market, the possible drastic fluctuations of these two are not considered in the design, and no in-depth sensitivity analysis is made.

    The risk-free rate of return is not mentioned first, because the impact factor of this variable is small and the frequency of significant changes is low. Next, let’s just talk about the volatility, which is a core variable that is generally missing in DeFi.

    Volatility

    Volatility measures the volatility level of return on assets. In finance, it is often measured by the standard deviation of return on assets in a given period (generally known as historical volatility, which is used to estimate the implied volatility).

    In option pricing, volatility is an indispensable and extremely sensitive variable, but this variable is dead written or adjusted by governance in current DeFi.

    Taking MakerDAO as an example, two important parameters ensure the stability of DAI: mortgage rate and position closing line (clearing line). However, these two parameters are not dynamically adjusted, that is, the contract is written at the beginning, for example, the mortgage is 50% off and the position is closed at 20%. If you want to adjust this indicator, you need the so-called chain governance, not automatic change of the system.

    Similarly, the same is true for us to borrow money from Compound. The mortgage rate and closing line are determined in advance and will not be automatically adjusted.

    However, under normal circumstances, the design of these two variables is reasonable. However, when the volatility rises sharply, it will present a very realistic challenge: sell out. Once you are out of position, you have to ensure the stability of DAI, which is impossible. The function of stabilizing currency will gradually lose efficacy. Since the fluctuation rate is not as obvious as the price change, and it is often relatively stable, these DeFis can operate stably and balance automatically in most cases. Even if Ethereum fell from $1400, MakerDAO would be able to circulate normally, and the mortgage scale would even continue to grow. Everyone felt that this reflected the greatness of decentralization.

    However, no matter how lucky you are, MakerDAO’s processing is ultimately missing one variable, and there is no feedback on volatility indicators.

    Volatility surged

    This kind of problem also exists in the AMM scheme that we will mention later.

    From a more abstract level, if there is less than one basic dimension variable, the participants can provide constrained information for the game. In the end, even if the equilibrium can be formed, it is also incomplete information equilibrium. Most of this kind of equilibrium is unstable: once it deviates from the track under some disturbances, it may never return, leading to the withdrawal of some participants and the end of the market.

    For example, in 312, MakerDAO was unable to deal with the sudden surge in volatility. The original position closing setting was broken by price fluctuation in a short period of time, resulting in some debt positions becoming insolvent. Due to this risk sharing mechanism, the intrinsic value of all DAI is devalued. In order to maintain the property of stable currency, MKR auction is adopted to restart manually, which is far from the spirit of DeFi. So later, the MakerDAO foundation also realized this problem. It did not want to and could not take responsibility, and gave the right of governance to the community.

    In fact, as a real DeFi protocol, it does not need to charge fees or governance rights. It is just a standard just like erc20 protocol. The premise is that the agreement should comprehensively reflect all variables of the service, instead of taking a model that is short of weight to deal with the complicated economic world.

    Logic and law

    Although we only cite the example of MakerDAO, the problems we reveal are universal. The absence of volatility makes all mortgage agreements go back to MakerDAO. This has nothing to do with luck. In the financial sector, we only believe in logic, not luck. Come out to mix, sooner or later is to return, today’s good luck, for tomorrow’s step on the pit buried foreshadowing.

    In the end, only logic and law can save you.