Decentralised finance, a.k.a DeFi, has been hurting The Blind Spot‘s head ever since we first heard about pancake swaps earlier this year.

Try as we might we couldn’t wrap our heads around it. What the hell was it? What was its point? How did it work? Why did everyone seem to know what was going on except us?

There were only two possibilities for this grating state of affairs.

1. We lacked the little grey cells to comprehend the true genius of crypto.
2. None of it made sense because it was all in fact mad or massively misrepresented.

The good news is that thanks to an extensive chat with Canadian bitcoiner, Brad Mills, on the second edition of the Blind Spot’s podcast, the proverbial crypto penny has finally dropped on what the frack is going on.

You can watch the podcast below or listen to it on Spotify.

DeFi, it turns out, is just an automated market-making system in which retail punters, family offices, and Canadian pension funds can play the part of algorithmically-guided market makers. You could call it the democratisation of market-making, but that’s being kind.

In reality, the system bears striking similarities to what might be considered a poorly collateralised intraday repo market.

Though the best description of all, we think, is that this is what might have emerged had Joe Public been able to invest and run the old LTCM strategy, which famously blew up in 1998.

For those who haven’t read Roger Lowenstein’s When Genius Failed (and shame on you if you haven’t – it’s a financial must-read), LTCM was born out of a similar intellectual conceit and tech snobbism that is apparent in today’s crypto space. The fund’s backers, academics Myron Scholes and Robert C. Merton plus former Salomon Brothers bond trader, John Meriwether, had convinced themselves and investors that they could make reliable outsized returns from running complex computer risk models with very high leverage. They even likened themselves to a “financial technology” firm rather than a hedge fund.

One of the fund’s best-known trades was the bond convergence trade. This involved LTCM taking two sides of a similar position as both buyer and seller. LTCM was usually betting that a subtle difference between these two positions (based on vintage or other properties), would eventually converge to its long-term average. To walk away quids in, LTCM only needed to warehouse the risk until the convergence happened. It was like picking up pennies in front of a steamroller, some had said.

As Roger Lowenstein describes in his book, this amounted to LTCM collecting a fee for its willingness, in most circumstances, to own a less liquid bond.

Eric Rosenfeld, another senior at the firm, described it as follows:

“A lot of our trades were liquidity providing,” Rosenfeld noted. “We were buying the stuff that everyone wanted to sell.”

Keep that in mind as we try to explain DeFi in normal speak.

A DeFi market is born

The story, as Brad tells it, begins with the birth of the Uniswap protocol. This was a workaround for folks who wanted to engage in crypto trading without having to pass the KYC or AML requirements that now apply at most formal centralised exchanges. It also appealed to those who objected to centralised exchanges on principle but weren’t keen on using conventional bilateral markets matched by brokers because of the expense and complexity.

Who wants to pay a broker a commission in the brave new world of “backed by math” asset classes?

With DeFi – and the birth of the Uniswap – there could be another cleverer way. Oh yes. And that involved making order books public on a blockchain.

In a conventional exchange-based marketplace, an exchange brings many counterparts to a single location and stands between them as a common intermediary. This assures liquidity because everyone knows where to go to meet counterparts as and when they need them.

An exchange, however, also manages the order book and sets the rules by which participants’ buy-and-sell orders square off against each other.

Liquidity is the key to the success of any exchange because it means anyone can trade without moving the price excessively. Liquidity, however, is a function where there are many offsetting counterparties present.

But even exchanges can’t guarantee that there will always be offsetting parties available when you need them. This is why they often offer incentives to market-makers to operate in their markets.

The inventors of Uniswap looked at this state of affairs and thought, hey, if the secret to exchange liquidity is a bunch of committed market makers then all you really need to make decentralised exchange work is…a bunch of committed market makers.

Ta-dah! DeFi was created.

It took the form of a system wherein counterparts club their order flow together on smart contracts linked to public blockchains. Anyone who wants to trade can do so because they can be sure a wall of pre-committed standby orders will be there to trade against – and the orders are there for everyone to see.

Why automated market-making bears risk

In the real world, a market maker is not supposed to take directional bets. They are supposed to be price agnostic, or, as is also known, market-neutral. Whatever position a market maker takes, they are supposed to immediately hedge and/or trade out of it. The way a market maker makes money is instead from the spread, which is the difference between the price at which they buy an asset and the price at which they sell it. As long as the spread is priced correctly (i.e. he buys the asset at a lower price than its value at the time of selling), the market maker can make money from buying and selling the same asset.

In the real world, market making is a professional business that requires good knowledge of risk management so that the spread charged accounts for market volatility and the risk that a position cannot be traded out of at a profit. It also requires a significant balance sheet – it’s not easy to become a market maker as a result.

In DeFi, risk management is outsourced to an algorithm and the balance sheet is generated by the aggregation of many multiples of mini retail balance sheets.

Punters instead commit individual coin capital to making markets across dedicated legs (or swaps) individually. This process is known as staking and, in theory, the more money punters stake in so-called liquidity pools, the greater the liquidity of the market.

The overarching reason to stake capital as a punter is confidence that the algorithm will always assess market conditions correctly and return you to market-neutral status, having earned a spread.

In reality, a viable marketplace is only created by splitting crypto punters into liquidity providers (i.e. the “automated” market makers described above) and liquidity takers (those who want to use the system to place outright directional bets).

TradFi people might call these committed liquidity pools a “float”. They might even be inclined to call such “liquidity providers” depositors.

When algos go wrong

The problem for the DeFi system is that it is continuously competing with centralised exchanges. If spreads are priced too widely in the system, they run the risk of being unable to attract any liquidity takers at all. If they are priced too narrowly, they run the risk of having the market move against market makers before they can return to a market neutral position.

For example, if the bid-ask for bitcoin on an exchange is $20,000-$20,010, DeFi can only compete by offering a narrower spread, say bidding for bitcoin at $20,001 and offering to sell at $20,009. If its spread is wider than the exchange’s, it might be able to absorb any unexpected price moves and still make a profit, but chances are nobody will want to trade at those levels at all. The bid-ask on a centralised exchange is about a cent worth, which is pretty narrow.

When markets move quickly, the offsetting side of a market-making trade can disappear before it has the ability to be executed; the value projected by the algorithm turns out to have been wrong. When this happens liquidity providers get “rekt”. (Weirdly, getting rekt is sometimes considered a badge of honour).

Being a liquidity provider is therefore a fairly binary matter. You’re either making a spread or getting rekt.

Hedge funds found this feature particularly attractive. They understood how such an asymmetric environment could be taken advantage of if the risk was properly priced.

The biggest of these asymmetries was the fact that in a rising market anyone operating a default stablecoin as the go-to “market neutral” position (and most people were) is always at a greater risk of doing better than expected when volatility strikes.

This is because the market is surprising to the upside.

Since nobody minds being liquidated by a counterparty into a winning position, or inheriting an exposed position that only goes up in value, this dynamic for a long time obscured the true scale of risk being taken by liquidity providers.

Most punters were walking away quids in no matter what happened.

In a down market, however, these same virtuous circles become vicious circles. Getting rekt in such circumstances – especially if your market-neutral position is a stablecoin – more often than not means losing value. If you’re operating the mirror trade, the mere fact that you are defaulting to a market-neutral position that is constantly going down in value undermines your gain. Any yield you generate at this point has to outperform the potential value destruction from the market-neutral position.

Suddenly, things are not so rosy.

Leverage games and money creation

If you thought that was crazy enough, you haven’t heard the half of it…

Conventional crypto exchanges are not exactly fussy about what coins they list, but even they draw a limit somewhere. With DeFi, however, there are no limitations at all.  All you need to be “listed” is a pool of dedicated market-makers happy to support your coin in a swap.

And what better way to attract such market makers than to lend them the very token they need to support their market (on ridiculously favourable and even negative-rate terms).

What DeFi protocols thus encouraged, according to Brad, was the creation of pre-mined tokens or blockchains specifically for liquidity-providing purposes. Taking part in such arrangements became known as yield farming.

The lending rates in the market rarely made any sense either, says Brad.

The practice often saw coins manufactured from thin air and lent (or in some cases even given away) to market makers exclusively for the purpose of being staked into liquidity pools to be traded against other tokens, most frequently stablecoins. Adding to the madness, stablecoins were also starting to be lent out on similar terms to support the markets from the other side. Sometimes to the same operators at equally non-sensical rates.

With everyone being paid to trade on all sides, the result was a type of highly institutionalised wash-trading, with yields upon yields being stacked on top of each other, creating the illusion of super-sized returns. In reality, most people were trading with themselves.

“Professional” crypto lenders like Celsius, meanwhile, realised that if they oriented their “lending business” around their own crypto collateral – by paying out returns in their own native units – they could attract huge sums of assets into their networks.

Some might have called the whole phenomenon unregulated banking. But that would be unkind to banks, since banks tend to have standards and a desire to lend to real businesses.

Others might say that the more risk-averse crypto players at least operated on a collateralised (or over-collateralised) basis. However, since the collateral they pledged was rubbish (such as UST Terra and the like), this didn’t necessarily add security either.

Not that the quality of the collateral mattered to DeFi enthusiasts. In their mind, they had fixed the problem of leverage by coding strict liquidation protocols into smart contracts. This assured that if a margined position was ever breached, the position would be immediately closed out and the collateral or loan returned to the lender. Since over-collateralisation is also common, the risks of not being able to liquidate in-the-money were low.

What could go wrong? Contagion. Forced liquidation is the surest pathway to daisy-chain-style collapse across the entire cryptosystem.

If you thought “Flash Boys” were bad

While transparency is usually considered a good thing, in highly efficient markets it can also render a large natural buyer or seller with a big disadvantage. For example, if you are a large pension fund or natural hedger, having your intent to buy or sell broadcast to everyone on the exchange can have very detrimental effects on execution costs. If people can see your massive order flow coming, they can front-run it and make it far more expensive for you to trade.

This is why conventional exchanges offer services like “iceberging”, which obscure the true size of trades to limit their impact on the market.

In DeFi, because all liquidity provider positions are known and committed to large whales (and others who can get their hands on capital easily) can wait and watch on the sidelines until the perfect market depth manifests to achieve their objectives. That might be pumping the market higher, or tanking it to close out some shorts. Whatever the agenda, this transparency offers the opportunity to front-run known order flow profitably.

And what better way to exploit such opportunities than with the capacity to borrow large amounts of capital quickly on an uncollateralised basis, safe in the knowledge that if the trade doesn’t work out profitably it will never be recognised by the blockchain.

And the reason that can happen, is because those doing the lending are often the miners who have the power to recognise a transaction or not. If the trade works, they get a cut of the proceeds. If it doesn’t, they simply don’t add it to the block.

Some might call this arbitrage; others, however, would call it market manipulation.

Really, it’s equivalent to when the LME decided to unwind the massively out-of-the-money nickel trades by Chinese tycoon Xiang Guangda in the wake of Russia’s invasion of Ukraine on opaque and preferential grounds…but normalised. The LME, on the other hand, is being sued by other members for showing such favouritism.

The question for crypto is to what degree this free-for-all is going to backfire on everyone.

Arguably, we are now at the point in the story when what used to be considered sure bets are being exposed as anything but because, in a down market, what used to be virtuous circles are turning into vicious ones. Meanwhile, the underlying capital backing the whole system is being exposed as pretty worthless.