The Coinbase series of articles Around the Block aims to clarify the key issues in the field of encryption. In this article, Justin Mart analyzes three industries affected by the recent market crash.
The loan market: behind the scenes of interest rate growth
The cryptocurrency lending market has seen strong appeal. Over the past few years, an estimated $ 13 billion in total loan sources has come from traditional institutions and native cryptocurrency products.
For the purposes of this article, the lending market enables participants to:
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- Coinbase: Bitcoin's correlation with traditional markets is temporary
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- Lend their cryptocurrency to others and get interest rate payment
- Borrow cryptocurrency against published collateral to get interest rate fees
These markets can be provided through central intermediaries or smart contract platforms, which are designed to ensure that capital losses are avoided. The main source of income for companies in this area is the net interest deposit, in which participants obtain the price difference between the interest rate provided to the borrower and the interest paid to the lender.
But lending activities are accompanied by risks. Borrowers may default on their loans, especially when the underlying collateral (cryptocurrency) experiences large fluctuations. In this article, we have studied the performance of the loan market during the most recent cryptocurrency crash on March 12. However, before going further, we first need to understand the mechanism that drives interest rate growth and its relationship with market conditions.
Why do people need loans?
The borrower borrows cryptocurrency or cash for some form of collateral and for the following purposes:
- Speculative activities-long or short cryptocurrencies by borrowing cryptocurrency and selling to get cash (buy short) or borrowing cash and buying cryptocurrency (buy long) Both are important mechanisms. For investors, especially during periods of high volatility, these are mechanisms that amplify returns and / or hedge risks.
- Working capital-working capital, used to carry out business or personal affairs. Bitcoin as working capital is very important for many enterprises (such as miners, OTC, remittances, proprietary trading companies, etc.) that need to obtain a large amount of funds to promote operations. In addition, borrowing is usually not a taxable business, so it is an opportunity to maintain cryptocurrency exposure without incurring tax penalties.
- Derivative arbitrage
A deeper explanation for derivative arbitrage. Take the Bitcoin futures contract as an example. These contracts are agreements for buying and selling Bitcoin at a certain price in the future. The pricing of these markets reveals investor sentiment. Generally, if the BTC futures market is bullish, the price of buying or selling Bitcoin in the next 3 months is higher than today's spot price.
The difference between the spot price and the futures price represents the opportunity for arbitrage through cash-out transactions. If the 3-month BTC futures price is 5% higher than today ’s spot price, then savvy investors can borrow cash today to buy BTC while shorting in the futures market (locking the 3-month trading price at a 5% premium), at Effectively get 20% APY in the next three months. If the interest rate charged for borrowing cash is less than 20% annual interest rate (APR) (and any other fees) within 3 months, you will benefit from the difference.
Cryptocurrency market sentiment is usually net bullish. The average trading volume of Coinbase Consumer is 60% of purchases, the borrowing demand for leveraged long trades is net long, and the futures curve is usually bullish. This sentiment drives demand for cash lending, but what happens when the market turns to bearish?
First of all, cash transactions have become encrypted transactions, you can borrow BTC instead of cash to obtain futures arbitrage, and then immediately sell and buy long futures contracts on the spot market.
When the futures curve turned bearish, the loan market turned to crypto lending and the demand for cash lending dried up.
Considering the trading volume of the derivatives market (usually> 5 billion USD / day), sometimes there are sometimes huge differences between futures and spot prices, and derivative arbitrage is usually an important source of borrowing demand.
What drives interest rates? Why are DeFi interest rates usually high?
Like any market, rates are ultimately a function of supply and demand, but there are deeper mechanisms at work:
- The cryptocurrency lending market accepts cryptocurrency as collateral …: For many cryptocurrency institutions and individuals, their deepest capital pool is cryptocurrency, which is the only viable way to mortgage.
- The use of cryptocurrencies as collateral usually has higher risks: cryptocurrencies are more volatile and therefore more difficult to adapt to loan risk models. This not only limits the number of companies that accept cryptocurrency as collateral (reduced supply), but also requires higher interest rates to take risks.
- Due to improved efficiency, stablecoins are more popular than cash: it takes time to convert cash into cryptocurrencies. Many borrowing use cases require immediate action, so options can only be used in encrypted local solutions that are ready to deploy stablecoins. This increases the demand for stablecoins.
- The DeFi loan desk is still a niche market, and it is challenging to access: only those who participate in it know how to access DeFi services such as Composite and think about risks. This will change, but supply is still restricted today.
- Take the risk of smart contracts: The DeFi platform is a collection of smart contracts that may be easily exploited. Greater risk requires higher interest rates.
These effects together lead to an increase in stablecoin and crypto lending / loan rates, especially in DeFi.
We expect that as cryptocurrency adoption rates increase, these interest rates will eventually compress over time. More and more lenders will accept cryptocurrencies as collateral, stablecoins will be increasingly adopted, the bridge between cryptocurrencies and fiat currencies will become more efficient, DeFi will become more mainstream, and will be able to Good protection against smart contract risks. Before this, we can enjoy higher stable currency loan APY in places like Compound, Dharma and Dy / Dx.
What happens when the market collapses, and what should we pay attention to in the future?
The current market situation is due to a large amount of stable currency borrowing demand from speculation, working capital and derivative arbitrage. But when market sentiment changes:
- Increased borrowing of cryptocurrencies: to hedge risks (shorting)
- In the case of increased risk, the situation of borrowing more funds is reduced: even if you believe that the market will rise for a long time, huge fluctuations will quickly wipe out your position
- Futures curve turns bearish: shifts stablecoin demand to cryptocurrency demand
Compound's loan interest rate shows the strength of this conversion:
As market sentiment returns to bullishness and volatility declines, we should expect stable currency borrowing demand to rise and may reach previous levels. This will be an important development because many cryptocurrency companies rely on a stable stablecoin APY rate to subsidize growth. These are new crypto banks like Dharma, Linen and Multis.
Overall, cryptocurrency lending / loaning is an important business today, and may grow in the future. Market sentiment specifies demand preference, but overall demand remains high in bullish and bearish markets. Coinbase will seek to expand lending / loan services where possible to increase lending / loan liquidity and help the crypto market achieve its mature goals.
Stable currency: market volatility brings opportunities for growth
Before delving deeper, let's review their use cases in the crypto market today:
- Synthetic USD for trading and speculation: Many exchanges do not have regulatory approval to provide real fiat currency services. However, the main trading and speculative activities take place between fiat and cryptocurrencies, and stablecoins enable the exchange of long-tail transactions to provide synthetic fiat currency books.
- Settlement: Stablecoins provide the benefits of cryptocurrencies (fast, global, and cheap settlement) without disadvantages (price fluctuations), and are increasingly used for the settlement of goods and services. Interestingly, Asia seems to naturally adopt stablecoins in certain industries adjacent to cryptocurrencies, and Coinbase Commerce sees strong but nascent growth in stablecoin adoption.
- Capital flight: A stable currency like USDC is a globally open ecosystem, making it an attractive option for capital flight and dollar exposure.
Now, in response to the uncertainty of COVID-19, the U.S. government has issued a $ 2 trillion stimulus plan (16 times the entire Bitcoin market value), reducing the bank deposit reserve ratio to zero and lowering the federal interest rate To a record low level. At the same time, the financial market is very worried, and investors sell a large number of assets to manage leverage positions, hedge risks and seek stability.
So, what happened to the stablecoin market?
As the market collapsed, we saw some downstream effects:
- Increased transaction prices of stablecoins due to extensive security requirements
- As arbitrageurs cast stable coins to sell at a premium and meet demand, the issuance of stable coins increased
- There is a surge in on-chain activity, and investors shuffle between exchanges to manage positions or obtain arbitrage opportunities
The severity and duration of stable currency price shocks are directly related to the efficiency of entering and exiting fiat currencies. If anyone ’s experience of casting and redeeming stablecoins for real dollars is very simple, then any shock will be short-lived, as arbitrageurs will quickly intervene to maintain prices.
Let's see what happened to Tether. The USDT experience channel is not the best. Due to the peak demand, the trading price on March 12 was as high as $ 1.05. However, arbitrage brought the price back to the historical average within a few days.
At the same time, as of April 6, 2020, Dai's transaction premium is higher, but still a slight premium. This is a direct result of some deeper mechanisms behind the Dai ecosystem, including failure to keep its clearing engine running smoothly, resulting in a loss of $ 4 million in capital for MKR tokens (see below for a more in-depth analysis).
In terms of market capitalization, USDT has expanded its position as the dominant stablecoin, largely due to its position as the most liquid stablecoin (especially in Asia).
For many people, this is a strange trend because of Tether's seemingly suspicious history, close ties to Bitfinex and their apparent use of shadow banking, and repeatedly worry about their low reserves. People in the industry have different opinions on this, because at present it seems that Tether has at least 70% support, but in either case, as long as Tether continues to trade at $ 1 and expands its lead, the market does not mind.
For USDC, these are also opportunities for continued adoption. Although it may take longer to challenge Tether's liquidity, it has succeeded in gaining attention in other areas. In particular, with the help of Coinbase's USDC Bootstrap Fund, it cooperates with Coinbase Commerce in DeFi and may be applied to many emerging Neo-Bank and remittance applications. USDC has a regulated, fully supported stable currency, and has a smooth fiat currency entry and exit channel, which brings its market share outside Tether to 50%.
Stable coins will continue to exist and are being adopted every day. In addition, market turbulence is an opportunity to stabilize the growth of the currency.
Please note that the use of stablecoins does not represent capital leaving cryptocurrencies. Instead, it represents funds waiting to re-enter the broader cryptocurrency market, which is a promising signal for stablecoin adoption.
DeFi: MakerDAO clearing engine burst in market crash
MakerDAO is the smart contract DeFi platform behind the synthetic stablecoin Dai.
Some background on how MakerDAO works
The function of MakerDAO is that users release collateral (mainly ETH) to the smart contract "Vault" and print DAI according to the collateral of the vault. If its mortgage rate drops below 150%, its vault will be in default, and anyone can issue an on-chain transaction to close its vault and auction its collateral. This ensures that DAI still has sufficient financial support, or in the worst case, it can always be redeemed with a cryptocurrency of $ 1.
What happened when the market collapsed
On March 12, the price of Ethereum plunged by more than 50%, and briefly fell below $ 100 for the first time since 2018. This leads to two things:
- Several MakerDAO vaults have insufficient mortgages
- As people move funds to exchanges or adjust open positions, the Ethereum network has experienced severe congestion (transaction fees soared to about $ 2)
These two effects have downstream effects on MakerDAO. Usually, when the safe is closed and the collateral is auctioned out, there are usually multiple bidders to ensure that the collateral is auctioned at a reasonable price. But the price plunge also affected the entities (called "custodians") involved in these auctions:
- The custodian closed so many safes that many safes ran out of Dai and could not replenish the balance sheet quickly enough
- Many custodians are not prepared to pay high transaction fees, nor can they quickly mine their auction bid prices
This resulted in only one custodian participating in the bidding during the three-hour period. During this period, the only custodian bid for $ 1 to capture the collateral, and actually bought ETH almost free of charge.
Results and recovery
The end result: a custodian received almost $ 4 million in ETH for free, and the MakerDAO system did not receive enough funds to ensure that Dai was still fully over-collateralized.
Thankfully, MakerDAO has made plans for such accidents and added a second auction process, which requires MKR tokens to be minted and sold to make up for any bad debts.
This auction was recently conducted and Paradigm won most auctions at market prices. This actually means that MKR token holders experienced a dilution of $ 4 million, but Dai once again returned to a state of sufficient over-collateralization.
Ethereum's DeFi ecosystem is still in its early stages, and most of them are changing, so we should expect that huge market turbulence will bring downstream impact and exert pressure on the system in surprising ways. In this case, it will cause an opportunity attack on MakerDAO. This is part of the development process of DeFi, in which a major stress test occurs, we learn from failure, and the entire ecosystem gradually hardens.
The industry should not be afraid of Dai, which is deeply rooted in the ecosystem and is a key component of DeFi. MakerDAO's backup auction successfully recovered it from bad debts and was fully mortgaged again. However, this does mean that DeFi builders should carefully consider how to best mitigate downstream risks and consider the broader meaning behind major market volatility.