DeFI is an accident waiting to happen

But don’t blame ‘bad actors’ — accidents are a failure of the system

Is DeFi a house of cards?

As I write, the Celsius Network, which is basically an unregulated crypto hedge fund, is halting withdrawals on its lending platform, citing “extreme market conditions,” and a “need to stabilize liquidity.” It also said it was hiring restructuring attorneys to handle its financial problems. This is possibly the beginning of yet another crypto collapse.

Much of the reporting and analysis so far has focused on the people involved in Celsius — who are they, and how is this their fault? These are important questions, but they miss the broader point. If we shift our focus of blame away from individuals or institutions, and more towards the system itself, we find that the collapse is a result of features of the system — not bugs.

When something bad happens, we tend to blame the ‘human in the loop’, when really, we should ascribe fault to the system. Madeleine Clare Elish, a cultural anthropologist who researches automated systems, calls this phenomenon a “moral crumple zone,” wherein “responsibility for an action may be misattributed to a human actor who had limited control over the behavior of an automated or autonomous system.”

Moreover, in our eagerness to blame people we often fail to see that the true culprit is a system wherein accidents are ostensibly inevitable. In Normal Accidents, sociologist Charles Perrow describes such systems as:

• “complexly interactive”, i.e. components of the system interact in complex and sometimes unexpected ways

• and “tightly coupled”, i.e. there is no slack in the system — the component parts cannot be isolated from one another.

So, no one part of the system explains the accident. Rather, it’s how the parts of the system interact — which is often hard to predict — that causes the accident. ‘Who is responsible’ is often the wrong question. Instead, we should ask more about what is driving the system to make conditions so favorable to repeated accidents.

Is DeFi a normal accident waiting to happen? According to a recent paper by law professor Hilary J. Allen, the system is set up in increasingly complex ways that can make “financial products (and their possible interactions with the broader financial system) harder to understand, increasing the chance that risks will go unanticipated.”

Now, I can already hear the chorus of crypto bros yelling at their laptops that Celsius isn’t DeFi! They’re right, it’s not. Celsius technically falls in the ‘CeFi’ or centralized finance category. It’s not a protocol, it’s a crypto hedge fund that services borrowers and lenders: those who lend their tokens to the fund get a bonkers-high yield, and those who borrow pay a rate. Unsurprisingly, there are more people who want to earn yield rather than borrow. To make up the difference, Celsius uses lender’s tokens to make risky investments in DeFi protocols. These bets aren’t disclosed — hence the ‘unregulated’ part. Furthermore, it’s inextricably linked with DeFi, and as we witness its unraveling, we get a nice lil’ tour of the system’s dynamics. Allen’s framework highlights two: leverage and rigidity.

Let’s start with leverage: for Celsius, the story begins with ETH tokens stuck in a box.

Ethereum in a box

ETH is stuck in a box because the ethereum blockchain is completing a merge from “Proof-of-Work” to “Proof of Stake.” Until then, people can put their ETH in a box and get stETH in return. stETH is essentially a token that serves as an IOU that is fully backed by ETH. It just can’t be redeemed until the merge takes place.

What Celsius has done is accepted ETH from lenders, offered returns of 19%, and turned it into stETH — allowing them to do ETH-type things in DeFi, without actually using ETH. So in effect, their lenders are (or have been) earning a return on the representation of a token, while the original sits in a box. As mentioned, Celsius is able to offer these rates because they invest the stETH in risky DeFi projects. They make their own yield by (in theory) making even higher returns than offered and pocketing the difference.

What I’ve outlined above is exactly the kind of thing that creates leverage: the more assets one has to borrow against, the more leverage in the system. As Allen writes, “An unconstrained supply of financial assets means more opportunities for asset bubbles to grow, and more assets to be dumped during fire sales.” stETH, for example, was effectively created out of…nothing. Anyone who knows how to code can create a token, and then that token can be used for myriad purposes — for example, a Celsius wallet shows that it used stETH as collateral for hundreds of millions in stablecoin loans. It’s hard to quantify how much leverage is in DeFi but according to estimates by Noelle Acheson, head of market insights at Genesis Trading, it is currently at an all-time high.

🏦 Now seems like a good time to dust off the part of your brain that remembers the 2008 financial crisis, and compare it to the structure of DeFi. I’m not a finance expert but Allen sees similarities. In 2008, for example, credit default swaps — which act as an insurance policy on the default of a borrower — increased leverage in the system. You don’t have to own the underlying asset (typically a bond) to buy a swap, so lots of people were exposed to the same asset.

This brings us to the next dynamic: rigidity. Smart contracts are a piece of code that executes when certain conditions are met, thus relieving the system of the need for intermediaries. So when the market goes to the moon, there are no intermediaries taking a cut, and the investor experiences a higher return. Smart contracts — so smart! Wahoo, automation! But, once a smart contract is written into the system, you cannot undo its actions (mostly!), which makes it very rigid indeed.

Leverage combined with the rigidity of a tightly-coupled system is problematic. Allen explains:

“When critical parts of the financial system become overleveraged, flexibility may be needed during the bust cycle to release the largest entities from obligations to respond to margin calls or repay loans – otherwise the failures of intermediaries and fire sales will have ripple effects that can drag down the whole system.”

The inability to reverse or change what a smart contract does can cause system-wide problems. In Allen’s paper, she explains that many DeFi loans (which are something that Celsius engage with) are automatically liquidated if there is insufficient collateral, and that “there may be situations where the stability of the financial system would benefit if smart contracts simply didn’t execute”. One such moment might have taken place earlier this week when in a span of 24hrs, DeFi markets experienced $1B in automatic liquidations.

Another rigid feature of DeFi is staking. Remember that ETH stuck in a box?

Since Celsius’s risky stETH investments have not paid off, they now really need to get that ETH out to meet redemptions — but they can’t! So, in effect, Celsius is insolvent. That’s why they’re halting withdrawals and hiring lawyers! Wait… aren’t lawyers ‘intermediaries’??

📉 In 2008, the rigidity was in the contracts for mortgage-backed securities, which often prohibited modifications. Law professors Anna Gelpern and Adam Levitin show how these contract features “produce a species of hyper rigid contracts that boost commitment in good times but function as suicide pacts in bad times,” like a mortgage foreclosure crisis.

Having someone to blame for all this is gratifying — cathartic, even. And yes, Celsius is at the center of this mess because they took on too much leverage. They definitely deserve their fair share of the blame. But don’t let this finger-pointing distract you from the wider systemic issues at play. The collapse we are currently witnessing is an indictment of a system that treats the dynamic interaction of leverage and rigidity as features to be celebrated, rather than bugs to be avoided… or regulated.

In 2008, we waited until the financial market collapsed to put regulations in place. At the time of writing, Three Arrows Capital (3AC), a crypto trading firm, also looks like it’s on the brink of insolvency. Given the dynamics in the system, contagion is likely to spread. Crypto enthusiasts and Congress both agree that DeFi and CeFi need to be regulated. Right now, the SEC is taking the ‘bad actor’ approach, focusing on regulation via enforcement. But if regulation is to make any meaningful difference — now and in the future — it must focus on the system dynamics that make DeFi and CeFi a normal accident waiting to happen.