What happens when collateral becomes liquid?
While the past year was a tough one for the public crypto markets, talented and dedicated teams spent it heads down, shipping what appear to be some of the building blocks of a truly open financial system. As a result, while 2017 was the year of the ICO and 2018 was the year of continued massive private token sales, 2019 is shaping up to be the year of Open Finance.
Most significantly, Maker, which launched at the tail end of 2017, has created a system for minting a USD-denominated stablecoin (DAI) using Collateralized Debt Positions (CDPs). The system has performed incredibly well, with DAI smoothly retaining the dollar peg and CDPs sucking up >2% of all ETH, during a year in which ETH declined as much as 94% from its all-time high.
Maker isn’t the only way to borrow or lend cryptoassets. Dharma allows users to request or offer loans for any ERC20 (fungible) or ERC721 (nonfungible) asset, dYdX enables derivatives and long/short margin trades, and Compound offers money market borrowing/lending for ETH, DAI, and a handful of other tokens.
Decentralized exchange (DEX) protocols (e.g., 0x, Kyber), are now functional, as are 3rd party exchanges and interfaces to access them (e.g., Radar Relay, Easwap), allowing non-custodial trading to become a viable reality, though liquidity is still somewhat lacking across the board. In November, a new completely on-chain DEX launched that makes it possible to provide liquidity and earn fees automatically using basically the same approach as Bancor, but simplified to remove the unnecessary token. Hello, Uniswap!
We now have (almost) fully decentralized options for borrowing, lending, and trading cryptoassets, creating derivatives around any asset or event, and even a USD-denominated stablecoin that allows risk-off positions and greatly improved UX without ever needing to directly touch that dirty, dirty fiat.
One of the core tenets of Open Finance is that of permissionlessness. But if there are no gatekeepers, then how can we be sure that a borrower won’t default on a loan or that a derivative will pay out as intended?
In a nutshell: collateral is posted as a form of insurance for the other participants in the system, so that you can be trusted to take certain actions without anything else being known about who you are, where you live, how competent you are, and so forth. If your actions ever come close to harming the system, you are automatically booted out and some or all of your collateral is handed over to more responsible parties.
In the Maker system, in order to borrow dollars in DAI, you must lock more than 150% of the equivalent value in ETH in a CDP. If your collateral ratio ever drops below 150%, a “Watcher” will step in, and *POOF* — your collateral is liquidated at a 13% penalty to repay your loan. Compound and Dharma employ similar structures to ensure lenders don’t need to be worried that borrowers won’t repay their loans.
Naturally, builders and participants in the Open Finance ecosystem have tended to think of assets used as collateral as just that: assets in use as collateral. Those assets may eventually be released and used for other purposes once a loan is repaid, but for now, their raison d’être is to be collateral.
But what if it doesn’t have to be that way?
There are currently over 2 million ETH locked in Maker CDPs, generating around 78 million DAI. That means at current prices, more than half the ETH in CDPs isn’t even technically required for collateral. It is a completely dead, unproductive asset.
Sowmay Jain, founder of InstaDApp, recently proposed automating the process of sweeping excess ETH out of CDPs and into Compound’s money market protocol to earn interest (the process of moving ETH back to the CDP as needed would also be automated, of course). That is a great first step and one that is relatively straightforward to implement by integrating the Maker and Compound protocols as they exist today.
But what about the rest of the ETH that is sitting in the CDPs, ensuring that they meet the minimum 150% collateral requirement? Why couldn’t that also be sitting in a Compound money market, available for others to borrow and earning the current 0.27% APR?
While a single unit of ETH can’t literally be in two places at once (one of the primary breakthroughs of Bitcoin was in solving the “double-spending problem”), there’s no reason why deposits into Compound couldn’t be made through a “deposit token” contract, which issues an equivalent number of “Compound ETH” or cETH (or cDAI, cREP, etc) ERC20 tokens. These cETH tokens would always be redeemable 1:1 for ETH in Compound. Ryan Sean Adams points out the same approach could be used in the future by staking pools with staked ETH.
Given this reliable, transparent backing, once Multi-Collateral Dai is shipped, it’s not hard to imagine that cETH could be added as a supported collateral type for Maker. Especially with speculation that much Maker activity today is driven by ETH holders who are looking to go long with leverage, it makes sense that there would also be demand for earning interest on the ETH that sits as collateral.
cETH is a fairly basic example of liquid collateral, but what if liquid collateral was actually used to provide… liquidity?
Uniswap is a fully on-chain decentralized exchange. Rather than maintain an order book, Uniswap uses liquidity pools and an automated market maker to determine the price at which an asset can be traded. If you want to supply liquidity to the exchange and earn a proportional share of the 0.3% fee charged on every trade between a given asset pair, you just deposit an equivalent amount of ETH and the relevant ERC20 token. (If you want a deeper explanation of Uniswap, check out Cyrus Younessi’s excellent overview.)
The ETH/DAI pair is currently the second deepest liquidity pool on Uniswap. Both assets are also available on Compound. It would be great for anyone providing ETH/DAI liquidity on Uniswap to also earn interest on their assets by having them simultaneously available on Compound for borrowing. Again, the cETH-type trick would work here for half the equation (cDAI), but it feels like there’s potential to do a more direct integration or re-writing of the two protocols to make this possible.
A different trick with Uniswap that definitely works is using the liquidity pair itself as collateral (e.g., ETH/DAI, as opposed to each of the assets in that pair, ETH and DAI). What does that mean? Well, although most Ethereum wallets don’t show them by default, whenever you deposit liquidity into a Uniswap pool, your share of that pool is actually represented by ERC20 tokens.
Any system willing to accept as collateral both assets in an ETH/XYZ pair should also be willing to accept the corresponding Uniswap pool shares as collateral. Uniswap’s automated market maker function ensures that the combined value of the ETH/XYZ pool share will never drop more than either of those two assets. In fact, all else equal, the value of the ETH/XYZ pool shares will rise over time, based on earnings from trading fees being added to the liquidity pool.
I predict we’ll see Uniswap pool shares used as collateral for millions of dollars in loans in months, not years.
Anyone familiar with the world of prime brokerage services will immediately recognize the process described in the preceding sections as forms of rehypothecation: a lender taking an asset posted as collateral by a borrower, and using that same asset as collateral to take out another loan. Except in this case, we may see collateralized collateral collateralizing collateralized collateral… and so on and so forth. Oy.
This creates a daisy-chain situation: if there’s a failure at any link along the chain, all of the assets further down the chain will also fail, but anything further up (i.e., closer to the original underlying collateral) should be fine.
However, it’s extremely unlikely this chain of collateralization would be created in a neatly serialized fashion. All available evidence suggests that financial engineers will slice, lever, mix, and sling every imaginable asset in every imaginable combination to create new products they can sell to each other or the unwashed masses. It will probably end up looking more like this:
Is this really any worse than the legacy financial system? Probably not. Technically, this would all be publicly viewable and auditable, rather than hidden behind a series of closed doors and incomprehensible legal contracts. We should be able to devise systems to track and quantify risk when everything is linked together via public ledgers and immutable automated contracts. We should be able to self regulate, put in place reasonable standards, and refuse to interact with contracts/protocols that don’t demand conservative margins and ensure the collateralization chain doesn’t go more than a couple layers deep.
But given what we know of human nature, do you really think we’ll show restraint when the possibility exists to earn an extra point of yield or pay a slightly lower rate on a loan?
There is something undeniably compelling about all of this. If assets can be allocated for multiple purposes simultaneously, we should see more liquidity, lower cost of borrowing, and more effective allocation of capital. Most of the builders I’ve met working on Open Finance protocols and applications are not looking for ways to wring a few extra bips (basis points, not Bitcoin Improvement Proposals… sorry) out of the system; they’re trying to build the tools that will ultimately make every imaginable financial asset, service, and tool available via open source software on the phone of every person on the planet. Maybe we’ll never get there, but based on the hyperspeed pace at which this industry is evolving, if this is all a big terrible idea, at least we’re likely to figure that out while it’s still only a few million nerds losing their shirts, rather than causing the entire global financial system to crash and burn.
In the meantime: superfluid collateral, anyone?
U.S. Treasury Targets Stablecoins in Latest Regulatory Risk Assessment
As regulatory pressure mounts in the U.S., policymakers are putting stablecoins at the top of their agendas.
Citing “people familiar with the matter,” Bloomberg has reported that officials are crafting a policy framework set to be released in the coming weeks. Their primary concern is ensuring that investors can reliably move money in and out of tokens, it added.
The anonymous insiders are worried that a “fire-sale run on crypto assets could threaten financial stability and that certain stablecoins could scale up dangerously fast.”
Strengthening Regulatory Efforts
The Financial Stability Oversight Council is also preparing a formal review into whether stablecoins pose an economic threat.
The officials are focusing on how stablecoin transactions are processed and settled and whether market conditions have an impact, it added. Tomicah Tillemann, global head of policy at a crypto fund run by venture capital giant Andreessen Horowitz, commented:
“It is significant and very consequential that we are witnessing early steps to create a regulatory framework around digital assets. That’s a big deal.”
The report, when released, will go to the President’s Working Group on Financial Markets. The body includes key agency heads such as Treasury Secretary Janet Yellen, Federal Reserve Chair Jerome Powell, and Securities and Exchange Commissioner Chair Gary Gensler.
In late July, Yellen called for urgency in regulating stablecoins after stating that they are not adequately supervised. Gary Gensler echoed the sentiment in early August, stating that regulators must act to protect investors from fraud.
Also, in late July, Acting Comptroller of the Currency, Michael Hsu, said regulators are looking into Tether’s commercial papers to see whether each USDT token was really backed by the equivalent of one U.S. dollar.
Tether has repeatedly issued assurances that its reserves are fully backed but has yet to produce a full independent audit.
Stablecoin Ecosystem Update
Tether remains the market leader with a current supply of 69.4 billion, according to the Tether Transparency report. This is close to the all-time high for USDT, which tapped 70 billion earlier this week.
Of that total, 36 billion or 51.8% is based on the Tron network, with 33.8 billion or 48.7% running on Ethereum. USDT supply has grown by 232% since the beginning of the year.
Rival stablecoin, USDC, from Circle currently has 29.3 billion in circulation after gaining 651% in terms of supply growth so far in 2021.
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Cardano, Chainlink, MATIC Price Analysis: 19 September
Most altcoins in the market have been consolidating or recording losses over the last 24 hours. Cardano fell by 3% and inched closer to the support line of $2.20. Chainlink also depreciated by 5% and was trading closer to its three-week low price. Lastly, MATIC was seen moving closer to its one-week low price of $1.29 after registering a loss of 5% over the past day.
Cardano lost 3% of its valuation over the last 24 hours. The altcoin was priced at $2.33. Over the last few days, ADA has been consolidating. The nearest support line for the coin stood at $2.20 and then at $1.72.
On the four-hour 20-SMA the alt’s price was seen below it, indicating that the momentum belonged to the sellers. The Relative Strength Index was below the 50-mark. The Chaikin Money Flow also was seen below the half-line as capital inflows were low.
MACD witnessed a bearish crossover and flashed red bars on its histogram. If ADA moved on the upside, the first resistance mark stood at $2.49, toppling which it could retest $2.79. The other price ceiling stood at the multi-month high of $3.04.
Chainlink was priced at $27.80 after it recorded a loss of 5% over the last 24 hours. LINK’s nearest price floor was at $27.78. Falling below which the coin could trade near its three-week low of $24.45.
Parameters pointed towards negative price action. On the four-hour chart, LINK’s price was below the 20-SMA. This reading suggested price momentum was inclined towards the sellers. The Relative Strength Index was below the half-line.
Awesome Oscillator flashed red signal bars. MACD also displayed red bars on its histogram. On the flipside, once buying pressure revives, the altcoin could attempt to retest the $32.37 resistance mark and then revisit $35.83.
MATIC depreciated by 5% and was trading at $1.39. The altcoin’s immediate support line was at $1.29 which also is the one-week low price level. The other price floor was at its over a month-long low price point of $1.07.
Bollinger Bands converged, indicating that price volatility would remain low over the upcoming trading sessions. MACD was bearish with red bars on its histogram. The Relative Strength Index was also seen below the half-line.
MATIC’s movement on the upside could mean that the coin would meet with its first resistance at $1.42 and then at $1.54. Toppling over these levels, the coin could revisit its multi-month high of $1.76.
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The Crypto Mining Fight in China Is Not Over
It looks like China is still not done clamping down on the crypto mining space. Another region known as the Hebei province has agreed to comply with Beijing’s ruling that all crypto mining should be omitted from China’s workforce. The province is now claiming that the practice is illegal and must end within its borders no later than September 30.
China Is Still Kicking Miners Out
China shocked the world not too long ago when it decided that all crypto mining should cease. The idea was that energy used for crypto mining purposes was hazardous to the planet, and that it was setting humans on the wrong path. Thus, regulators stated that it was time to bring things to an official end.
What was most surprising about the ruling is that the country, at the time, was home to nearly 75 percent of the world’s total crypto mining operations. Thus, it stood to lose a lot of money and tax revenue by initiating the clampdown. In addition, the country is home to two of the world’s biggest developers and distributors of bitcoin mining equipment in Bitmain and Canaan Creative.
Nevertheless, China has moved forward in its decision. Many mining operators were forced to shut down their businesses and move elsewhere, and quite a few have popped up in countries such as Kazakhstan and in states like Texas and Florida. Both these regions in America have stated they are open to crypto mining projects given that they can potentially lead to healthier local and state economies, and they will create jobs for interested workers.
The Hebei province issued the following statement:
Cryptocurrency mining consumes an enormous amount of energy, which is against China’s ‘carbon neutral’ goal.
The arguments against crypto mining have become rather prominent in recent months. One of the most notable stemmed from Elon Musk, the South African entrepreneur behind billion-dollar companies such as SpaceX and Tesla. He stated early in the year that he was willing to permit bitcoin payments for electric vehicles. A few weeks later, however, he rescinded this decision, claiming that miners were not utilizing their energy correctly, and he could not condone bitcoin unless carbon emissions were brought down.
Too Much Bad Energy in the Air!
Another argument came from Kevin O’Leary of “Shark Tank” fame. The billionaire investor claimed that he would no longer be purchasing any BTC mined in China given that the country was not known to utilize green energy for mining purposes. China later took this issue to heart, it seems.
Starting in October of this year, bitcoin and crypto mining in China will be completely illegal. Regulators in the nation have stated that they will keep a close eye on the mining space and will work to punish all those who disobey the rules.
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