Is Decentralized Finance Imploding?

“You can’t issue unlicensed securities and use your friends as the underwriters,” I told someone who’s much smarter than me a few months back.

We were debating decentralized finance (DeFi), and the extent to which quite a lot of it seemed flagrantly fraudulent to me.

Conversations like ours take place all the time. Almost invariably, the interlocutors are an intellectual mismatch. I’m not the smartest person in the world. I’m quite arrogant, but I’ve never pretended to be especially brilliant. I owe quite a bit of what I know about Web3 to people who are brilliant, and in that regard, I’m not so different from countless other “traditionalist” latecomers to crypto. Developers, programmers and quants built Web3, and if you want to learn about it, you need to talk to some of them and then immerse yourself in the experience.

But a respectable showing in undergraduate calculus won’t make you Einstein, and neither will one “semester” in Web3 make you a developer or a quant, so conversations between people like my friend and I typically end one of two ways, depending on who the more gracious person is. I’m never the more gracious person. “I’m sorry. I can’t. It’s fraud,” I said. He sighed, despairingly. “Ok. I won’t try to explain it to you again.”

He’s a quant. A real one. I’m not. So, he’s smarter than me. Although being a gracious person, he politely insists otherwise.

I’d emphasize, again, that these conversations are all too common. Earlier this month, Emily Stewart, a journalist at Vox, penned an engaging piece called “What is the point of crypto?” The click-friendly title belied a well-crafted, textured journey through Web3, where Stewart embarked on what sounded like a miniature version of the expensive, unguided tour I took earlier this year. “It’s a strange conundrum: If you don’t get it, you feel compelled to hedge by saying maybe you just aren’t smart enough to get there,” Stewart wrote, of conversations with developers, programmers, quants and industry insiders. “Maybe the hyper-complexity is a sign something weird is going on. Or, at the very least, this all isn’t ready for the mainstream,” she added.

My own view, as documented across multiple articles this year, is that “something weird” is in fact going on, where “weird” means that the decentralized exchanges (DEXs), automated market makers (AMMs) and decentralized autonomous organizations (DAOs) are, in many, if not all, cases, running some iteration of a Ponzi scheme.

That’s hardly a novel observation. Late last month, Bloomberg’s Joe Weisenthal and Tracy Alloway invited Matt Levine to join them on an episode of their “Odd Lots” podcast. They dutifully introduced Levine as a “Bloomberg Opinion columnist,” but that’s about like inviting David Rubenstein onto your podcast and calling him a “Bloomberg talk show host.” Levine is an M&A attorney. He also printed money in IB at Goldman and clerked for the 3rd Circuit. He’s a smart guy and the point in inviting him was apparently to offset another smart guy, Sam Bankman-Fried, CEO and co-founder of FTX. The two of them discussed “yield farming,” the process of extracting rewards and interest on DeFi platforms, which I summarized in March as “Ponzi meets hyperinflation.”

Bankman-Fried used what he called a “toy model” to describe the dynamics. He was remarkably forthcoming. “I think of myself as a fairly cynical person,” Levine said, when Bankman-Fried took a breather. It was an understatement. Levine is a cynic’s cynic. “And that was so much more cynical than how I would’ve described farming,” he added. “You’re just like, ‘Well, I’m in the Ponzi business and it’s pretty good.'”

You can read the transcript of the exchange here, but note that the discussion took place on April 25, just two weeks before TerraUSD, an algorithmic stablecoin that played an outsized role across some DeFi platforms and protocols, lost its peg to the dollar, subsequently dragging its floating balancer token, Luna, into oblivion.

From a psychological perspective, the Luna meltdown could fairly be described as one of the most devastating blows to the DeFi dream yet. The figure (below) shows total value locked (TVL) across all major protocols. It basically halved during the Terra drama. From the peak, in November, DeFi bets are down some $150 billion.

TVL is a simple metric. If you deposit (“stake”) your tokens with a project on the expectation of receiving rewards (i.e., “yield farming”), that’s value locked.

As Bloomberg noted, Anchor, Terra’s premier staking protocol, was “responsible for driving most of the $40 billion ecosystem’s value [and] advertised yields as high as 20%” before TerraUSD broke the peg.

The figure (below) shows that in and around the Terra tragicomedy, TVL across platforms saw record one-day declines.

In colloquial terms: If TVL dropped to zero, DeFi would be a ghost town. A collection of empty “boxes,” to employ Bankman-Fried’s metaphor.

It’s important to note that all of this is highly self-referential, and in ways almost no one outside the cryptosphere understands. In a May 16 note, Kaiko, a crypto research firm, wrote that “negative market sentiment hit perpetual futures markets [and] Avalanche funding rates in particular dipped sharply after the LUNA collapse as fears circulated that the Luna Foundation Guard would sell nearly 2 million AVAX tokens it held to defend the TerraUSD peg.”

Those fears weren’t immediately realized, but note that Avalanche matters. It’s one of the crypto “generals,” as I call them. Along with Solana, Avalanche was a 2021 darling and ranks fifth among chains in TVL terms, with more than $4 billion locked across some 200 protocols. Last week, Avalanche fell as low as $22. The figure (below) shows the coin’s peak-to-trough drawdown.

Solana, the only true Ethereum competitor, suffered a similar drop.

In a separate note, Kaiko observed a spike in Ethereum liquidity on centralized exchanges. That, they remarked, “is due to a decline in staking demand on DeFi applications following Terra’s implosion.” The plunge in TVL “suggest[s] strong capital outflows from the space,” the same note said.

During the three months I spent wandering around DeFi casinos, I was unable to discern any real purpose for their existence other than staking, farming and the facilitation of trading. Nothing is actually being accomplished. That was the biggest red flag for me, and it’s why I exited substantially all of my positions in late March, as discussed in these pages on numerous occasions.

“Who is all this for?” Vox’s Stewart wondered. “Crypto proponents are hoping it’s for someone, though it’s often not clear who or why or what,” she added, before quoting a cybersecurity analyst who said, “[People keep] trying to contort it into something useful, and it never gets there.”

On May 25, in his regular column, “Money Stuff,” Levine talked about the resurrection of Terra. A few days ago, Do Kwon, Terra’s founder, won approval to transfer the LUNA ticker to a new coin on a new blockchain. Describing the original setup, which included the stablecoin and “classic” Luna, Levine wrote that,

TerraUSD, certainly, looks like debt: You buy [it] for a fixed amount ($1), and you expect to get back that fixed amount ($1), and while you hold it you earn interest. Luna, meanwhile, looks like equity. It has no fixed value; it went up as optimism about Terra grew, and went down as Terra imploded. Luna could go to zero if Terra failed, or it could go to the moon if Terra became the world’s dominant financial system. There was no floor and no cap on Luna’s value.

Of course, Terra isn’t, strictly speaking, a company. So, the stablecoin, when staked, wasn’t debt. And Luna wasn’t equity. Right? Well, that was my quibble when I discussed DeFi with my friend — the conversation mentioned here at the outset. I wasn’t talking specifically about Luna, but I could’ve been.

Unlike me, Levine is a lawyer. Or was a lawyer. And, as it turns out, he thinks my quibble might have some merit. Specifically, he wrote that,

One implication is that you might think: Wait, if these coins are the debt and equity of a company, aren’t they securities? If they are securities, and they were sold to US investors, aren’t they required to be registered with the US Securities and Exchange Commission? If they are securities that were sold broadly to the general public and then lost almost all of their value, shouldn’t the SEC investigate? If big US crypto trading firms and venture capitalists were buying huge piles of Luna from Terra’s promoters and dumping them to retail buyers on exchanges while also talking up Terra, making billions of dollars for themselves while they “cash[ed] out on the backs of retail,” weren’t those big investors breaking US securities laws? Weren’t they underwriters of an unregistered securities offering, and shouldn’t they have to buy those coins back from those retail bagholders at the prices they paid? These seem like good questions!

They do indeed seem like good questions, which is why I asked them months ago, not of Terra, and not in public, but of another project, in private.

But maybe I’m just not smart enough to understand. As Stewart put it, “Maybe it’s true that the doubters are just confused.” But then, she wrote, “Maybe it’s that there’s not much to get.”

New Luna (or “Terra 2.0”) was airdropped to owners of Terra Classic tokens on Saturday. According to CoinMarketCap pricing, it fell 67% in a little over 24 hours.

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