Discussion of
Systemic Risk in Decentralized Markets

Paper by Alfred Lehar & Christine Parlour
Discussion by Andreas Park

AFA 2022

What is Decentralized Finance?

decentralized finance =
provision of financial services without the necessary involvement of a traditional financial intermediary at extremely low costs

key ingredient =
blockchain technology =

a common infrastructure for decentralized code execution

"DeFi refers to a fast-growing and highly opaque corner of the cryptocurrency market which allows users to engage in a variety of financial activities – including lending, borrowing, and trading derivatives to take on leverage – without an intermediary like a bank.
Given that participants and project developers may remain anonymous, DeFi could present particularly severe financial stability risks.
According to a 2019 Financial Stability Board report, decentralized financial technologies may raise new forms of concentration risks, unclear allocation of liability, and recovery and resolution challenges."

Source: Letter to Janet Yellen, Chair of the Financial Stability Oversight Council (FSOC) https://www.warren.senate.gov/imo/media/doc/FSOC%20Crypto%20Letter%2007.26.2021.pdf

The prevailing view among angry middle-aged folks

“[…] the need for a coordinated and cohesive regulatory strategy to mitigate the growing risks that cryptocurrencies pose to the financial system”

DeFi Risks

Risk regulation and avoidance in defi

What risks do we worry about in traditional financial markets?
What's different about DeFi?
What new risks emerge in DeFi?

Wrong approach: map traditional world to DeFi and regulate the hell out of it

Right approach: understand what's new and different and what's the same

Traditional Finance Risks

market

liquidity

credit/counterparty

operational

regulatory

systemic

What's different about DEFI?

self-custody

no-recourse

high transparency

miner interventions

composability

exploits

"hidden" smart contract features

oracles

Decentralized Finance Risks

market

liquidity

~~credit/counterparty~~

~~operational~~

regulatory $\subset$ systemic

composability $\subset$ systemic

scam/custody hacks

liquidity

~~credit/counterparty~~

"dark forest"

exploits

smart contract

oracle risk

self-custody $\to$ worry about all risks

DeFi Borrowing

4 ETH
(1 ETH = $3000)
(Jan 8, 2022)
$\approx$ $12,000

$\vdots$

up to 8,000 DAI
(1 DAI = $1)

formally: this smart contract is a collateralized debt position (CDP)

"over-collateralization ratio: 150%"

fractional collateral $\to$ collateralization factor $=$ 150%

\begin{array}{rcl} &&\textsf{maximal amount DAI borrowable \$}\\\\ &=&\frac{\textsf{\$ equivalent of ETH in escrow}}{\textsf{collateralization factor}}\\\\ &=&\frac{12,000}{150\%}=\$8,000 \end{array}

total collateral = $12,000

maximum loan = $8,000

overcollateralization = $4,000

actual loan (example) = $4,000

buffer = $4,000

DeFi Borrowing

user perspective: what happens if the price of ETH falls?

ETH $\searrow$ $1,500

value of ETH collateral = $6,000

maximum loan = $6,000/150%=$4,000

total collateral = $6,000

maximum loan = $4,000

overcollateralization = $2,000

actual loan (example) = $4,000

buffer = $0

for reference: former value of collateral

user perspective: what happens if the price falls & max loan is exceeded?

ETH $\searrow$ $1,250

value of ETH collateral = $5,000

maximum loan = $5,000/150%=$3,333

total collateral = $5,000

maximum loan = $3333

required overcollateralization = $1,667

actual loan (example) = $4,000

buffer = -$667

for reference: former value of collateral

Loan liquidation

pay oracle price $\times 95\%$

(max liquidation is 50%)

What do you do with the collateral? - SWap to DAI

Where do you get the collateral? - Flash loan

1. borrow DAI

5. repay DAI

2. liquidate ETH loan with DAI

3. receive ETH

4. convert ETH to DAI

Economics:

borrow $1,000 DAI
receive $1,050 ETH for $1,000
pay swap fees
pay gas fees

https://chiragkhatri.me/compound-liquidator/

https://zengo.com/understanding-compounds-liquidation/#Section_3_Liquidation_in_practice

Some observations

phenomenal system
integrated/composable apps, transparency, accessible to anyone
in many ways, as pure a market as economists could dream one up

details matter:
- Where does Compound get the price from?
- Does the conversion trade have price impact?

This paper

What do they do?

collect extensive data on liquidations

show that trades have price impact
~42% of initial price movement persists

$\ldots$ per "account"

Figure 9: Return distribution for 16 tokens that serve as collateral over 5 minute intervals that coincide with liquidations and ones that do not.

Looks like stochastic dominance!

Finding: returns with vs. without liquidations

Returns/Price Impact

When? Regression result: "waves" of liquidation have lasting impact, one-off events do not.

What could explain the findings?

lasting price impact for pure liquidity trades is surprising
with blockchain transparency, the market should figure this out
- shift in willingness of market to absorb inventory risk?
- information?
- or (boring) maybe the market isn't fully developed yet
Idea (may be a stretch):
- liquidation is costly and preventable
- price movement that triggered came as shock
- the shock is new information
- $\to$ liquidation is informative

Path forward

Use the per-account data: What are the characteristics?
- Active liquidators more likely in wave?
- Connected to miner to avoid MEV?
- Have more or less price impact?
- Do they make more or less money per liquidation?

Oracle risk
- Cream Finance exploit manipulated an oracle
- Is there evidence of liquidation triggering?

Leverage risk
- With collateralization ratio $\delta$ one can leverage capital $K$ to create position $K/\delta$.
- Do we see this? Are these more or less likely to get liquidated? (Info story?)

Systemic risk
- suggests risk of unravelling
- what are the odds? examples?

Summary

Start of an exciting and important research agenda:
- collect data on loan liquidations
- quantifying risk in DeFi
Nice finding:
- genuine liquidity trades have price impact
Many questions on DeFi risk and markets remain
$\to$ lots of papers to write (for all of us)!