In the past few months, decentralized finance has been all the rage, and the price of its tokens proves this excitement.
However, although the goal of decentralized finance is to create a financial world without a central authority , it is actually managed through efficient and seamless smart contracts and operated through cryptocurrency . Therefore, it may not actually achieve this lofty goal, nor one of its goals, and CDO is the worst financial experiment of the century.
A CDO is a mortgage-backed debt or packaged debt securities issued by a bank, invested by an investment company and sold to investors, mainly from the mortgage market. The foundation of the entire CDO market is the US housing market, and when the real estate market collapses, that is, when the homeowner cannot pay for the house, the pyramid collapses and the entire system collapses.
According to estimates by the International Monetary Fund, between January 2007 and September 2009, banks in the United States and Europe lost US$1 trillion, mainly on toxic assets and non-performing loans .
What happened is quite similar in the DeFi world, what happened was the same as debt mortgage bonds ten years ago. Richard Red, head of research and strategy at Decred, said in an interview with AMBCrypto that because DeFi has a high reputation, it also means that there are many vulnerabilities that can be exploited, so the field has attracted great attention. This attention is exposing loopholes in the smart contracts of many protocols and highlighting that the system is not very reliable at all.
Richard said, “This situation has many similarities with the mortgage debt problem (complexity masked risk) that led to the 2007 financial crisis.”
Comparing DeFi with CDO, we see an interesting pattern.
The packaged and repackaged CDO is the latest financial product on the market, allowing all parties to participate in the creation and transfer of debt. Here, the company established a debt mortgage based on the possibility of repaying the debt, and these things that are unlikely to be repaid are marked as "subprime mortgages."
Although the rating agencies have evaluated the debt, they have given a high degree of evaluation to the combined debt. These collaterals are sold to retail traders and institutional investors. Essentially, this approach is like this: if the homeowner pays regular interest, then everyone can make money, and if no one pays, they can make money.
DeFi also has an " all-round " aura, bringing all types of financial companies into the field, from lenders to borrowers to insurance companies. Richard explained that gathering so many people under one system would bring profit taking.
"In general, DeFi users stringing together different protocols and smart contracts may cause some systemic risks , because each smart contract relies on the input of other smart contracts to operate in a predictable manner."
Out of the motive of making huge profits, more people poured in and the chance of system defects increased. Richard said that because of this situation, "novel agreements" are being promoted, and in general, they "may not be relied upon in all situations."
Similar to what happened with CDO, some banks profited from it, and many other banks decided to join it. As mortgage-backed securities become "new things", this has aroused people's attention. Because of this rush, even the more mature banks cannot figure out how to manage debt securities and whether they can be repaid in full . This information vacuum eventually created a bubble, and then the bubble burst again.
"The complexity caused by the interaction of all these novel agreements means that even experts have difficulty knowing exactly what is happening, and unexpected events that are difficult to explain often occur."
Although still in its infancy, the growth of the DeFi ecosystem has begun to become "barbaric growth." Scrambling to profit will only attract more people, which puts pressure on existing institutions to deliver poorly structured products to meet demand. If this situation does not change, then the correction depends on when it happened, not whether it happened.