How Market Volatility Is Shining a Light on DeFi’s Structural Vulnerabilities

On March 12, United States President Donald Trump gave a 10-minute speech on COVID-19 that, coupled with the World Health Organization’s official declaration the day before that the outbreak was now a pandemic, sparked panic across global markets.

Investors rushed to the safety of cash, and no cryptocurrency was immune from the mass sell-off. The total market capitalization of the cryptocurrency sector plummeted by over 25% in a span of hours. Bitcoin (BTC), despite its reputation as a safe haven, fell by 48% in a span of 24 hours. Ether’s (ETH) loss of 43% was its worst one-day performance.

While cryptocurrency prices have rebounded in the interim, the decentralized finance sector has continued to feel the repercussions of “Black Thursday.” As a result of ETH’s sudden losses, millions of dollars' worth of value was liquidated and DeFi applications temporarily stopped functioning.

Price volatility is inherent to cryptocurrency investing, but mass liquidations and faulty applications mustn’t become the norm for DeFi. Its foundational philosophy is the removal of centralized intermediaries in the financial system, but this lofty goal will be unobtainable if the mechanics of DeFi are breakable. Crypto assets will always be volatile, and DeFi’s infrastructure must be shored up to withstand day-to-day price changes, no matter how dramatic.

As a starting point, the DeFi community must address three key pain points that are interconnected:

The DeFi space is overly reliant on Ethereum assets.
Liquidation-based approaches to cross-chain value transfers are dangerous.
Multisignature and multiparty computation mechanisms are insufficient for ensuring liveliness and safety in DeFi environments.

Each of these points warrants deeper analysis.

DeFi’s Ethereum dependence poses systemic risks for the sector

A common mantra in the world of financial advice is to avoid “putting all of your eggs in one basket.” In other words, holding a diversified portfolio ensures that you won’t lose too much money if a particular sector of the economy crashes.

In the DeFi sector, all eggs are in Ethereum, which controls the fortunes of DeFi applications and investors alike. For example, users of popular systems like MakerDAO mostly use Ethereum as collateral. When flash crashes of Ether happen, users scramble to recollateralize and the network becomes congested. This makes the DeFi sector uniquely vulnerable to fluctuations in Ether’s price and network congestion. For DeFi systems to scale, these systems need access to larger market-capitalization assets like Bitcoin, as well as a more diverse range of cryptocurrencies.

For instance, when ETH’s price tanked on Black Thursday, the outcome was predictably dire. Users of MakerDAO lost millions of dollars (more on that shortly), oracle prices lagged and applications like dYdX and Nuo had to alter their fees to force through delayed trades. This sequence of events was not without precedent: Ethereum’s network suffered similar congestion in 2017. Notwithstanding these problems, Ethereum is and should remain an important cog in the DeFi ecosystem, and the protocol’s plans for ETH 2.0 will hopefully help.

But in order to thrive and scale its community, DeFi applications should look toward cross-chain assets enabled by generic interoperability, which would allow collateralization with any crypto asset in return for any other crypto asset. Generic interoperability will provide greater liquidity for DeFi applications, mitigate ETH price exposure risk and lessen DeFi’s dependence on the Ethereum network.

Broadening DeFi’s range of cross-chain pairs will be especially important for spurring mass adoption. When stablecoins like Libra, Celo and even China’s digital yuan come online, cross-chain liquidity can serve as a bridge that encourages crypto novices to buy their first Bitcoin, Ether or other decentralized assets as a means of taking out stablecoin loans.

A liquidation-based approach to interoperability is dangerous

The Black Thursday experiences of MakerDAO and Compound, two of DeFi’s most popular protocols, offer an instructive case study into why liquidation mechanisms pose risks for DeFi participants.

When ETH’s price began plummeting the evening of March 12, MakerDAO’s oracles — the automated bots that ascertain price information for lenders and borrowers — were unable to cope with the speed and severity of the price crash. MakerDAO’s users were desperate to recollateralize their loans, but severe network congestion and outrageously high gas fees prevented them from both depositing more ETH (to maintain their 150-to-100 collateral-to-loan ratio) and paying back their Dai, resulting in $4.5 million of liquidations at absurdly cheap prices for liquidators. Compound suffered similarly with its highest number of liquidations at over $4 million, mostly in collateralized ETH.

Beyond Ethereum’s role in this debacle, it is worth focusing on this liquidation-based approach to decentralized finance. When network problems arise, liquidation-based mechanisms can wreak havoc on unsuspecting users. Positions cannot be recollateralized in time, loans cannot be repaid, oracles cannot update their prices, oracle prices lag from the true price, and liquidations stop functioning correctly.

This presents a serious challenge for bringing cross-chain assets and liquidity to DeFi. We mustn’t collateralize these assets with ETH or rely on liquidation mechanisms. If we do, DeFi systems might get access to cross-chain assets and liquidity, but we have just moved the risk of dysfunctional liquidation mechanisms somewhere else; we have not actually solved the problem. Worse, if DeFi then goes on to use these cross-chain assets as collateral themselves, then we are compounding liquidation risks. Worse still, the market cap of cross-chain assets becomes restricted by the market cap and volatility of ETH, which defeats much of the point.

Instead, DeFi needs cross-chain assets that are collateralized by native tokens whose value is derived only from the use of the assets. This way, the stability and market cap of cross-chain assets is not dependent on anything other than those assets being useful. Such systems do not only survive volatility and market panics, but thrive in them. Decentralized exchanges, which saw historic transaction volume and fee returns during Black Thursday, are an example of this type of system. Despite storing lots of ETH collateral, DEXs remain secure and useful in times of high volatility.

Interoperability solutions must go beyond multisigs and MPC

While both multisigs and multiparty computation mechanisms deserve our praise for bolstering crypto custody, neither are currently sufficient for securing the type of decentralized, always-on network that DeFi is striving toward.

Multisigs, by virtue of requiring multiple signatures to authorize any transaction, are incapable of scaling or enabling autonomous functions in a large decentralized setting. MPC is preferable and is an important technological breakthrough in securing decentralized networks, but state-of-the-art MPC is vulnerable to going offline when just a few nodes fail, and they have long, heavy pre-compute phases that are incompatible with 24/7 decentralized finance systems.

Therefore, to ensure lively and safe decentralized financial services, DeFi protocols must look to novel types of MPC that do not fail when the underlying participants go offline, do not have heavy pre-compute phases, and can remain stable and functional even in times of high market volatility.

The views, thoughts and opinions expressed here are the author’s alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.

Loong Wang is the chief technology officer and co-founder of Ren, an open protocol that enables the permissionless and private transfer of value between blockchains. Ren's core product, RenVM, brings interoperability to DeFi through a decentralized custody solution that allows the seamless movement of assets between blockchains.