FTX STARTS TO INFECT DeFi

The series of scandals we have seen in 2022 itself raises the question as to whether the industry can be trusted at all. Maybe the players of this techno-monopoly board game will themselves get fed up with the scams and stop playing it before governments step in in any meaningful way.

Some months ago, I wrote a column in this space on Decentralized Finance (or DEFI as it’s commonly called in the tech industry). DEFI allows apps that can create financial instruments using crypto currencies such as Bitcoin and Ethereum. As most now know, these crypto currencies rely on a piece of internet technology called Blockchain which has uses, both in the financial sector and outside of it. DEFI, where people borrow, lend and trade crypto without a central intermediary, had so far evaded the brunt of the FTX fallout.

Largely unregulated, DEFI had exploded in tandem with demand for cryptocurrencies like Bitcoin and Ethereum. For now, the ecosystem is populated primarily by people who are comfortable with crypto—with all its risk and legal uncertainty. I say legal uncertainty since countries are not comfortable with private players issuing their own currencies, let alone derivative transactions or other financial instruments based on such digital (crypto) currencies.?

Apart from just an alternate (and highly volatile) way to store value as an asset class, which seems to be all that crypto has been able to manage so far, DEFI unlocks the potential of digital currencies by allowing them to be morphed into financial instruments. At the first level of abstraction, these can be simple forward contracts on cash settlements, such as letters of credit used in the import/export world.?

But this sort of use is simple. In the DEFI world, there are several apps taking shape. Some of the more popular ones include apps such as PoolTogether, which have “loss-less” lotteries using Ethereum’s smart contract layer, which allows developers anywhere in the world to publish decentralized applications with limitless functionality. Unsurprisingly, this tool has been quick to provide value to the gambling industry which stands to benefit enormously by removing trust from both the players and middlemen. The best way to describe loss-less lotteries in Indian parlance is to liken it to the kind of chit fund that randomly picks the winner of the pot for the month, rather than by using a monthly auction methodology to determine the taker of the pot. Like chit funds, these apps have formed an alternate banking system for savings and loans, but they are based solely on a crypto currency and not the country’s legal tender. And like chit funds, they are not insured by any country’s deposit insurance mechanisms.

Now,?Bloomberg?(https://www.bloomberg.com/news/articles/2022-12-06/crypto-fund-orthogonal-defaults-on-36-million-debt-as-ftx-contagion-spreads?sref=q435HZax ) reports that the contagion from the implosion of Sam Bankman-Fried’s FTX crypto empire is impacting the world of DEFI, after a hedge fund was declared in default on almost $36 million of loans on 4th?December. Orthogonal Trading said in a tweet on Tuesday 6th?that it had been “severely impacted by the collapse of FTX and associated trading activities,” making it unable to repay on a $10 million part of the $36 million in crypto loans. That prompted the entity that runs the lending pool on the DEFI protocol Maple to issue a notice of default for all the fund’s active borrowings. Sister organization Orthogonal Credit (which claimed on December 5th?that Orthogonal Trading acted without its knowledge) had originated roughly $850 million in loans over Maple.

Loans arranged on unsecured platforms like Maple don’t require large pools of collateral to support positions in the event of a default, but instead rely on pool managers like M11 to conduct due diligence on borrowers’ financials. Maple said it severed ties with Sydney-based Orthogonal Trading because it misrepresented its financial position to the lending pool, M11 Credit. M11 Credit is a wholly owned subsidiary of Maven 11 Capital, a Blockchain and digital asset investment firm founded in 2015.?

In addition to Maple, M11 Credit also accused Orthogonal Trading of misrepresentation. “Rather than cooperating with us and disclosing their exposure, they attempted to recover losses through further trading, ultimately losing significant capital,” M11 Credit said, adding that it had been informed by Orthogonal Trading on 3rd?December about its inability to repay the $10 million.

The default is just one more example of crypto hedge funds getting jolted by the swift implosion of FTX last month. FTX was a favoured trading venue for institutional crypto investors. Several hedge funds have had their money stuck on FTX. As it is, the crypto world was stumbling from the big explosion of the so-called “stable coin” TerraUSD -- a digital token whose value was meant to be pegged to the US dollar using a parallel currency called Luna. It became popular when users of a DEFI platform called Anchor were offered interest rates as high as 20% for TerraUSD deposits. Sudden withdrawals from Anchor drove TerraUSD’s value down, and, within days, both it and Luna were in a death rattle that knocked off about $60 billion of their value.

I have long said that government should be doing more to regulate the world of crypto, and indeed the fall of FTX now supposedly has countries like the UK looking to regulate it. This may have something to do with Rishi Sunak’s statements early this year - before he became Prime Minister - that he was looking to reinvigorate the City of London (i.e., London’s financial district) by turning it into a post-Brexit crypto hub.?

Notwithstanding the UK’s efforts, the series of scandals we have seen in 2022 itself raises the question as to whether the industry can be trusted at all. Maybe the players of this techno-monopoly board game will themselves get fed up with the scams and stop playing it before governments step in in any meaningful way.

Siddharth (Sid) Pai has led over $20 billion in technology transactions. He is the co-founder of Siana Capital, a venture fund management company focused on deep science and tech in India. These are opinion pieces; the opinions expressed are the author's own and do not represent any entity.

This article first appeared in the Financial Express