When terminator robots police loan markets

Is decentralised finance a 21st-century utopia or dystopia? Two opposite views are starting to emerge

Nine days after Avraham Eisenberg began to borrow curve cryptocurrency tokens on Aave, a decentralised lending platform for digital assets, he found his $38 million loan abruptly liquidated by terminator bots.

An estimated $10 million loss on a failed punt sounds only mildly annoying, compared with everything else going on in Eisenberg’s life — the self-described  “applied game theorist” was arrested in Puerto Rico recently for allegedly draining $110 million from trading platform Mango Markets. Still, the zapping of the trader’s short CRV position, as the curve tokens are known, has sparked a lively debate.

The abruptly curtailed life of the loan is a feature of decentralized-finance, or DeFi, marketplaces that allow volatile cryptocurrencies to be lent against one another. The trader had borrowed CRV tokens by posting USDC, a dollar stablecoin, as collateral.

If this were conventional debt, the borrower would get a margin call when the lender became uncomfortable with the collateral covering it. On a public blockchain, anybody can track such situations. To keep the system safe, arbitrageurs are encouraged to step in. These are algorithms that raise a so-called flash loan (more on them later) to liquidate vulnerable short positions. They pocket a reward from the software code — smart contract — running lending protocols such as Aave.

Although not directly linked to the Eisenberg loan, recent work by academic researchers has concluded that DeFi harbors a systemic fragility, wherein liquidations engender other liquidations. Collateral prices get affected across trading venues; the malaise spreads. Flash loans are to blame — they’re so fast and frictionless that decentralized lending becomes inherently crash-prone.

At the opposite end are practitioners who believe teething problems are normal for a nascent industry. DeFi deserves a fair chance to create a cheaper alternative to intermediary-driven traditional 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 crisis?

In Eisenberg’s case, there’s nothing remarkable about his own loss. What’s problematic is that Aave, the platform, was left nursing a $1.6 million bad debt after algorithms — taking advantage of a 75% run-up in CRV on Nov. 22 — closed the short position. At first blush, this seems to be a point in favor of the fragility hypothesis of University of Calgary economist Alfred Lehar and Christine A. Parlour, a UC Berkeley finance professor. According to them, a crucial difference between DeFi and TradFi is that the former doesn’t place any capital constraints on arbitrageurs. Is that a problem? Well, it could be.