When Terminator Robots Police Loan Markets


Nine days after Avraham Eisenberg began borrowing curve cryptocurrency tokens on Aave, a decentralized lending platform for digital assets, he found his $38 million(1) loan abruptly paid off by terminator bots.

An estimated $10 million loss on a botched punt sounds only slightly upsetting, compared to everything else going on in Eisenberg’s life: The self-described “applied gaming theorist” was recently arrested in Puerto Rico for allegedly stealing $ 110 million from the Mango Markets trading platform. Still, the zapping of the trader’s short CRV position, as curve tokens are known, has sparked lively debate.

Abruptly shortened loan life is a feature of decentralized finance markets, or DeFi, which allow volatile cryptocurrencies to lend to each other. The trader had borrowed CRV tokens by posting USDC, a dollar stablecoin, as collateral.

If it were conventional debt, the borrower would get a margin call when the lender became uncomfortable with the collateral covering it. On a public blockchain, anyone can track such situations. To maintain the security of the system, arbitrageurs are encouraged to intervene. These are algorithms that generate a so-called flash loan (more on them later) to liquidate vulnerable short positions. They pocket a bounty from the software code (smart contract) that runs lending protocols like Aave.

Although not directly related to the Eisenberg loan, recent work by academic researchers has concluded that DeFi harbors a systemic fragility, in which selloffs breed other selloffs. Collateral prices are affected in all trading venues; the malaise spreads. Fast loans are to blame: they are so fast and frictionless that decentralized lending becomes inherently prone to crashes.

At the opposite extreme are professionals who believe that startup problems are normal for a fledgling industry. DeFi deserves a fair shot at creating a cheaper alternative to traditional intermediary-driven finance, or TradFi, which, for all the progress since the advent of the 17th-century goldsmith banker, still relies on expensive taxpayer-funded bailouts. Remember the subprime mortgage crisis?

In Eisenberg’s case, there is nothing remarkable about his own loss. What is problematic is that Aave, the platform, was left with a bad debt of $1.6 million after the algorithms, taking advantage of a 75% increase in CRV on November 22, closed out the short position. At first glance, this appears to be a point in favor of the fragility hypothesis of University of Calgary economist Alfred Lehar and Christine A. Parlor, a UC Berkeley finance professor. According to them, a crucial difference between DeFi and TradFi is that the former does not impose capital restrictions on arbitrageurs. This is a problem? Well, it could be.

DeFi lending and borrowing is anonymous. In the absence of credit rating, or recourse to the borrower or the borrower’s reputation, loans must always be worth considerably less than collateral, especially since the token borrowed and the currency against which it is borrowed can fluctuate wildly. To keep the lending pool secure, algorithms scour digital platforms for breaches of lending-to-value rules. When they focus on shaky debt (Eisenberg’s position exceeded the system’s allowable LTV of 0.89 on Nov. 22), they are programmed to seek a quick loan, use the proceeds to close a portion of the original debt, snatch the warranty and sell it to cancel your liability.

Unlike conventional finance, these four things happen in a single block of validated information. Either the transaction takes place in its entirety and all copies of the distributed ledger reflect it, or it doesn’t take place at all. That’s why bots don’t need to put up capital to pocket the promised liquidation incentive: 4.5% in the Eisenberg episode. They pose no credit risk to the lenders who advance the money to carry out the killing. “Experience is more likely to be constraint rather than capital due to the existence of quick loans,” Lehar and Parlor note.

That’s top marks for capital efficiency. But we must also count the cost to the credit system of the absence of friction. And therein lies the crux of the “where DeFi” debate: was the bad debt left behind by Aave the result of an unresolvable fatal flaw, or could it have been prevented by a design adjustment?

In a document covering the episode, a group of blockchain professionals have come up with a possible answer. Beyond a threshold, the November 22 sell-offs turned toxic. Each forced closing of his loan made Eisenberg’s remaining position slightly riskier compared to the available collateral. That, in turn, invited another bot and everything got out of hand. If the fixed 4.5% liquidation incentive had been dynamic, if it had progressively decreased with the thinning of collateral coverage, the platform could have prevented the accumulation of bad debts.

“Toxic selloffs are dangerous for the protocol, as they mathematically guarantee that the health of the user’s wallet will worsen through no fault of their own,” Jakub Warmuz and co-authors note. “As a general rule, short-sighted and sudden responses to complex dynamic behaviors lead to worse results than the response was intended to achieve. They should be avoided unless absolutely necessary.”

Corrections should come sooner rather than later. Not because our next mortgage is DeFi: good luck putting a municipality’s land registry on a public blockchain. The main motivation is that much of the conventional trade in goods could benefit if decentralized finance allows a case of wine or the Japanese yen owed by its importer to become an asset on the blockchain. So that money could be raised cheaper than would be possible now after paying the fees to the intermediaries. In November, JPMorgan Chase & Co. made a small transaction on Aave, taking its first live position on a public blockchain. With the TradFi giants starting to dabble in DeFi, everything is getting serious.

Whether the future of DeFi is utopian or dystopian is not something that finance professors or professionals can determine for themselves. A piece of software code that acts like a complete contract, leaving no room for the courts to step in if things go wrong, forces us to imagine, among other things, a less salutary ending to Shakespeare’s “Merchant of Venice.” Legal and cultural philosophers should also mark Eisenberg’s liquidation. They may soon have to get into the debate.

More from Bloomberg’s opinion:

• Will cryptocurrencies ever be a safe investment?: Andy Mukherjee

• Beware of the dangers of too much crypto regulation: Tyler Cowen

• Beware of crypto billionaires bragging about audits: Lionel Laurent

(1) See “Toxic Liquidation Spirals: Evidence of Bad Debt Incurred by AAVE”, an article by Jakub Warmuz, Amit Chaudhary and Daniele Pinna.

This column does not necessarily reflect the opinion of the editorial board or of Bloomberg LP and its owners.

Andy Mukherjee is a Bloomberg Opinion columnist covering industrial companies and financial services in Asia. Previously, he worked for Reuters, Straits Times and Bloomberg News.

More stories like this are available at bloomberg.com/opinion

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