In a financial system without supervision leverage can grow dramatically. Let's explore the impact of rehypothecation and lending haircuts on real balance sheets. In this example we refer to USD as the currency. That can be any stablecoin (or actual USD) it doesn't matter here.
Start with a BTC spot of 60k and an overcollateralization haircut of 25%.
Our "lender" begins with the following balance sheet:
The lender borrows 1M USD, in cash, and starts there. After making a single collateralized loan for 1 BTC they have:
The borrower has 48k in their bank account. As long as BTC stays above 48k -- where the liquidation occurs -- this transaction is on snooze mode. Let's say the borrower goes and buys 48k worth of BTC. That is buying pressure of 0.8 coins. Now pledge those coins to another lender. The two lender balance sheets are:
Of course the next step is to buy 0.64 coins and pledge them to someone else:
The aggregate system now has:
That is not crazy. If we allow the buy-pledge loop to run forever through these 3 banks we can generate more loans. And that generates an aggregate balance sheet of:
The total buying here is 4 coins. And we have 240k of loans outstanding against an initial collateral value of 60k. This is unsurprising as max leverage is just 1/haircut.
Over time, until there is a crisis, we know lending standards get looser. Let's say that is reflected in lower haircuts. At 10% it is useful to compare the "3 loans" and "infinite loop" aggregate balance sheets. Here we are still running the loans through a total of 3 banks -- total funding is still 3M:
The situation with 1 loan for each lender is pretty mild. But the infinite loop aggregate system is far more levered! This activity generated buying of 10 coins and leaves behind a liquidation order for 11.
With a haircut of 2%:
Now we are able to exhaust a system-wide total of 3M lending against a single coin. This process generates buy orders for 50 coins. And the aggregate liquidation order is for 51x the initial collateral.
Safety of the loans isn't even the primary concern here. This activity facilitated buying 50 more coins. This isn't someone trading 50x on an exchange -- each individual transaction here is just an at-market loan and a cash purchase of coin.
We don't even require the same person to keep taking out these loans. The simplest sequence of events is likely:
- Borrow against BTC
- Buy BTC with loan proceeds
- Deposit BTC into a yield generating protocol
- Protocol lends the BTC
That is a circle of collateralized. This is not a ponzi scheme and it's not a pyramid scheme. It's a long loop of borrow-buy-borrow-buy until the marginal loan is too small to bother. And it generates an awful lot of leveraged buying.
This does not happen in the regulated financial system because aggregate system balance sheet leverage is constrained. Obviously problems can, and have, occurred with excessive leverage. But each balance sheet is supervised by internal agents (i.e. the risk department), external agents (i.e. the bank's investors) and the regulators (i.e. banking, markets, securities, whatever).
It's a big ugly complex system. It's not perfect. But it is fundamentally different from a collection of smart contracts unconsciously running through that loop.
At a high level it is an empirical question which is safer. These systems have very different properties. It is, however, quite clear that loose lending in DeFi can directly lead to large coin purchases and leave behind large liquidation orders.
Each player has their own defensive arrangements in place. Without the possibility of extraordinary liquidity assistance it feels as though everyone will be forced to turn their cards over at once.
We propose the name "ouroboros scheme" for this configuration. As long as the underlying asset retains adequate value this can continue forever.
Scheme is meant in the British sense that does not connote something negative -- not the American sense which does carry a suggestion of something sinister. In the UK it is totally normal to have a "pension scheme." This term would scare Americans and many other English-speaking groups. Divided by a common language indeed.
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