As 2021 comes to a close, the leading lineup in the DeFi scene is largely made up of Synthetic Asset Platforms (SAP). SAP is any platform that allows users to create synthetics from derivatives, the value of which correlates with existing assets in real time. While oracles can provide reliable price information, synthetic drugs can represent any asset in the world and accept a price – be it stocks, commodities or crypto assets.
Thus, SAP is finally bridging the gap between new DeFi platforms and legacy financing, allowing investors to place bets on any asset, anywhere, in the comfort of their preferred blockchain ecosystem. SAP, which is decentralized and backed by the first layer of Ethereum, appears to be the next major catalyst for the growth of the cryptocurrency. However, unlike good money and verifiable artwork, decentralization and secure ownership in the lending world is certainly only half of the equation.
In conventional finance, debt securities are among the most prominent financial assets in the world, with a total value of about $1 trillion. Most people know them as mortgages, a term that dates back to 13th century France and literally translates to “mortgages”. It may be painful or melodramatic for the average person, but for the many millions of people who lost their retirement accounts, savings, homes and livelihoods as a result of the 2008 financial crisis, the terms “death penalty” and “damage to security” are irrelevant. Rather, couples express the longing and pain that awaits those who participate in lending, without first understanding the risks and consequences associated with it.
Here is the womb: in order to obtain a loan, the debtor gives guarantees, which are prohibited by the creditor by contract, which can forfeit the guarantee if the debtor is unable to service the debt. Unfortunately, servicing debt with securities is not as easy as paying interest on time, as the value of the underlying security can fluctuate sharply in response to broader market volatility, such as the sudden collapse of the mortgage housing sector in the United States. If the value of the debtor’s collateral falls below a predetermined threshold, the lender – be it a bracketed bank or a decentralized protocol – has the right to accept the collateral and liquidate it at market value to recover the outstanding loan principal. If the term “death oath” is too obligatory, you can also call it the carpet of life.
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Whether they are issued on Wall Street or on the Ethereum blockchain, the risks associated with financial products cannot simply be decentralized. Liquidation triggers are primarily related to exposure to fluctuations in the broader macroeconomic environment, which neither developers nor financiers can control.
MakerDAO Lesson on DeFi Space
Take, for example, MakerDAO, a purely decentralized SAP system whose security is closely linked to the DAI stablecoin with the US dollar. Ostensibly, the Maker presented an alluring opportunity for investors who could bet their idle cryptocurrencies to create a synthetic dollar. While DAI is stable, its supporting distributed security suite consists of some of the most volatile assets in the world, namely Ether (ETH) and Bitcoin (BTC).
To prevent a downturn in the cryptocurrency market causing mass liquidations, the Maker Protocol requires 150% extra security. In other words, users get only two-thirds of what they add to the protocol in dollars, which is a model that traders don’t like and that doesn’t support sufficient capital efficiency in the ecosystem. Moreover, the constantly volatile cryptocurrency market showed that Maker’s high security requirements were insufficient in March 2020, when a 70% drawdown wiped out Maker users across the board with losses totaling more than $6 million.
Popular SAPs learned from creators’ hardships and took extra steps to prevent catastrophic mass liquidations on their platforms. Or rather, they took more of the same action: Mirror Protocol requires up to 250% safe, Synthetix requires up to 500% of users fat. Of course, super capacity of this size is not enough to compete with traditional finance, where central brokerage firms offer the best quick settlement. But there is another problem as well.
For cryptocurrency traders who are not comfortable with the exorbitant collateral requirements and liquidation risk, it makes sense to forgo SAP altogether and buy stocks and synthetic commodities on the secondary markets.