First published in BanklessDAO’s Decentralized Law, “Decentralized Finance,” May 25, 2022.

Financial services regulation is complex and growing more complex each day. Regulators do not always understand which transactions, derivatives, or other financial instruments give rise to the need for regulatory intervention to prevent systemic risk or impact. Complicated financial products precipitated the financial crisis that began in 2007. Those that grew up during or in the wake of the crisis were understandably disillusioned. Legacy financial institutions and other market participants’ avaricious, self-serving, and predatory behavior arguably led to the U.S. federal government’s 700 billion USD bailout of Wall Street intermediaries, while normal people were left with an economy for a period that is now termed the ‘Great Recession’. As a result, developers began to imagine a financial services industry without traditional intermediaries, sparking ‘FinTech,’ and eventually decentralized finance.

A core goal of DeFi is to eliminate legacy financial market intermediaries such as investment banks, depository banks, exchanges, clearinghouses, and broker-dealers, and to increase overall liquidity, transparency, velocity of money, and decrease transaction friction. DeFi allows developers to create new types of financial products and services, eliminating aspects of counterparty risk, by allowing financial assets to be exchanged in a trustless way.

DeFi[ned]

DeFi is a commonly used term to describe the ecosystem of financial services built on decentralized blockchain technology, which replace traditional financial intermediaries with freely accessible, autonomous, and transparent on-chain contracts. DeFi protocols adhere to values of permissionless-ness and transparency. DeFi allows people all over the world to lend, borrow, send, or trade assets using non-custodial wallets and without having to involve a bank, broker, or other intermediary. Users can also explore more advanced financial instruments such as leveraged trading, structured products, synthetic assets, insurance underwriting, and market making while always retaining complete control over their assets.

As of February 2022, DeFi total market cap continued to reach new all-time highs, and cumulative revenue has grown to over 4.2 billion USD since June 2020. As new DeFi services recreate and reinvent elements of Traditional/Centralized Finance (interchangeably ‘TradFi’ and ‘CeFi’) services, and billions of dollars of digital assets are pledged to DeFi capital pools, policymakers and regulators are faced with challenges in balancing the risks and opportunities presented by this more transparent and permissionless financial system. While DeFi might offer greater efficiencies and opportunities for inclusion, there are also attendant considerations such as the extent of actual decentralization, governance complexities, technical risk, and ultimately systemic risk throughout a burgeoning composable ecosystem.

Disintermediation Is a Feature, Not a Bug

DeFi was developed as a peer-to-peer method of transacting without reliance on a system of intermediaries that has historically allowed artificial manipulation of markets and opaque redistribution of risk. DeFi represents an affirmative attempt to eliminate intermediaries in financial transactions. Instances where intermediaries have failed to appropriately manage counterparty risk often result in systemic market disruption where the costs of self-interested misconduct are generally externalized to the market and taxpayers.

Notwithstanding the goals of decentralization and the dynamic attributes of distributed digital ledger platforms, many cryptocurrency broker-dealers, clearinghouses, and exchanges currently operating in mainstream markets still rely on elements of traditional financial intermediation. For example, some platforms rely on centralized order books; others centralize aspects of trade execution or settlement. True decentralization is more often than not merely aspirational.

An alternative way to look at DeFi is that it does not actually eliminate financial intermediation, but enables new ways of performing those same intermediary functions through trustless codes and contracts which are programmed to reduce transaction costs and information asymmetry. Based on continuing infrastructure developments, DeFi platforms have the capacity to adapt, reduce, and possibly eliminate institutional intermediation in trading and transactions.

The Synthetix ecosystem is one of the earliest examples of a fully decentralized protocol eliminating traditional counterparty intermediation in derivatives trading. Two more recent innovative composable protocols in the Synthetix ecosystem are Lyra and Kwenta.

• Lyra Protocol is a collection of smart contracts that allow liquidity providers to provide capital for traders to buy or sell options to/from the market via an Automated Market Maker.

• Kwenta is a decentralized derivatives trading platform offering real-world and on-chain synthetic assets. Kwenta is built on the Synthetix protocol and traders can access synthetic liquidity entirely created by SNX token stakers.

There are no direct counterparties for a trade in the Synthetix protocol, but it does use a counterparty-like model where SNX stakers assume a proportion of the Synthetix debt pool when they mint sUSD (synthetic U.S. dollars). While these protocols arguably include aspects of the traditional intermediation process in their code, this automation and decentralization does not require the involvement of a self-interested counterparty or allow transactional opacity.

Counterparty Risk Management

Despite centralized financial institutions’ demonstrated lack of transparency, consumers and markets seem to place the utmost trust in them. Proponents of the traditional TradFi/CeFi regulatory regime highlight incidents involving technical failures and attacks on DeFi services resulting in loss of capital as reasons for implementing analogous regulation. However, this seems to be a simplistic argument and purposefully ignores repeated systemic failures in TradFi that have resulted from a lack of transparency and appropriate risk management.

Counterparty risk is the possibility that the other party to a transaction, the ‘counterparty’, will default on its obligations to a financial instrument. This could include failure to repay a loan creating a credit risk, or failure to settle a transaction by delivering the specified asset creating a settlement risk. TradFi industry and regulatory ‘initiatives’ to manage counterparty risk generally involve centralized control and regulation. Due to the interconnected contractual and economic nature of the relationships among the largest market participants, one financial institution’s default on its obligations adversely affects the financial institution’s trading partners, hindering their ability to meet their obligations, and so on down the chain. Systemic risk may also occur if an exogenous shock to the financial system causes widespread, contemporaneous losses across financial markets that trigger the collapse of one or more systemically significant financial institutions or a series of financial institutions.

To mitigate the classic ‘run on the bank’ scenario, regulatory efforts have historically focused on prudential measures such as board risk oversight, safeguarding solvency by imposing mandatory capital requirements, limiting the size or types of assets held, and limiting the types of permissible transactions. While regulators have established these mandates, authorities have generally delegated most counterparty risk management oversight to the self-interested market participants themselves. Despite these efforts at regulation and oversight, centralized systems seemingly allow artificial manipulation of risk constraints to benefit the very intermediaries that have been charged with preventing excessive systemic risk. This was recently demonstrated by the Archegos implosion.

Archegos’s TradFailure

In April 2022, Coindesk contributor David Z. Morris somewhat presciently highlighted the potential systemic impact of counterparty failures in the crypto market — using Archegos as an example and Luna/Terra as an analogous potential risk case. The Archegos example also highlights ongoing issues with opacity and TradFi disclosure and reporting ‘requirements’.

In March 2021, the family office fund Archegos Capital Management imploded, causing billions in losses to the prime broker intermediaries (including Goldman Sachs, Morgan Stanley, UBS, Nomura, Deutsche Bank, and Credit Suisse). The quick summary of what occurred is that Archegos duplicatively pledged collateral to multiple brokers to continually leverage-up trades on a portfolio of approximately ten stocks including Viacom, Discovery, and Tencent. The firm utilized total return swaps, which are functionally contracts between the broker and fund providing exposure to an underlying asset. The client gains — or loses — from any changes in asset price, and the broker, not the client, shows up in filings as the registered holder of the shares. As Archegos’ assets increased in value with the bull market, the leveraged position was continually increased. In March 2021, an unexpected drop in Viacom price forced a margin call, and the positions began to unwind as the underlying stock held by the brokers was sold into the market. The market impact of unwinding the heavily leveraged positions eventually led to billions in losses for the involved intermediary banks and impacted the market as a whole — albeit only briefly.

Archegos purposefully utilized various regulatory loopholes — or just ignored reporting requirements — to obfuscate their positions. Even though total return swaps are a legitimate financial instrument, the Archegos incident has focused regulatory attention on the processes and controls used by prime brokers to extend leverage. Archegos betting on certain stocks using total return swaps made it difficult for prime brokers to understand the full extent of Archegos’ positions and leverage. In addition, because Archegos was a family office — as opposed to a traditional fund — it was exempt from registration as an investment adviser with the U.S. Securities and Exchange Commission (SEC). The SEC and other regulators have suggested they could now start to scrutinize risk management systems more thoroughly, particularly if counterparties use synthetic structures to not only increase leverage but also to avoid disclosing it.

The most concerning aspect of the Archegos implosion is that the intermediaries   involved appear to have been highly culpable in allowing Archegos to take the positions that it did. Wall Street firms invented the swap derivatives used, provided Archegos with as much as 85 percent margin debt on the derivative trades and were collecting a huge amount of fees while also profiting on the stock underlying the leveraged swaps. Archegos is a prime example of where a failure to properly evaluate counterparty risk, due largely to lack of transparency, caused significant systemic risk. Standard practices for evaluating risk failed because the firms involved were not incentivized to appropriately monitor Archegos, at least until they sustained 10 billion USD in losses.

More Terra/Luna Stuff, Really?

Contrast Archegos’ implosion with UST’s depeg on the Terra blockchain and Luna’s consequent debasement. Allegedly, on-chain data showed significant selling of UST into other stablecoins for no clear reason — though it seems like it could be because the entire market was precipitously dropping at the time and investors were de-risking. There are already a variety of semi-conspiracy theories regarding Luna/Terra’s downfall. However, the algorithmic stablecoin structure and UST’s fast growth, seemingly without scaled backing funds, are also just as likely the cause as a concerted attack by an imagined bad actor. While both Archegos’ 10 billion USD implosion and Luna/Terra’s 40 billion USD collapse caused significant pain in the markets, an important distinction is that Luna/Terra’s algorithm, contracts, inflow/outflows, funding, etc. have always been open and on-chain. Arguably, there were no self-interested intermediaries allowing unmitigated counterparty risk to exist in exchange for profit.

The fallout from the Archegos and Luna/Terra incidents will, unfortunately, be what you would expect: more regulation. More centralization will always be the solution offered by regulators. If DeFi cannot protect against counterparty risk through decentralized means, it will be forced to adhere to standards set by centralized regulators. As DeFi evolves, which, and to what extent, regulators attempt to exercise jurisdiction will become increasingly relevant. In the U.S., the DOJ, CFTC, FinCEN, FINRA, and SEC may all attempt to implement some oversight on decentralized platforms and their customers. It is likely that many DeFi tokens will be considered securities and the SEC will mandate increased disclosure requirements. DeFi platforms may also be considered ‘exchanges’ under SEC jurisdiction and be required to submit to ongoing examinations.

The relative lack of centralized governance and intermediaries in DeFi arguably prevents or limits artificial manipulation of markets to redistribute counterparty risk. Given full transparency, decentralized markets may be better suited to assess risk and respond accordingly. DeFi systems should preclude the possibility of being as artificially risk-controlled as TradFi systems, helping limit the potential for poor management and irresponsible trading practices. That said, we also watched Luna/Terra go to zero — dragging Anchor with it — as the result of manipulation or breakdown of the algorithm and despite active intervention to prevent a digital bank run. Notwithstanding, DeFi’s major value lies in its ability to address systematic counterparty risk through disintermediation and transparency.

lawpanda is a U.S. attorney with an active litigation and counseling practice. He is a member of BanklessDAO’s Legal Guild, LexDAO, the LexPunkArmy, and member/consultant/contributor to a variety of DAOs and protocols. When he’s not writing for Decentralized Law, he is working to reduce operational and governance friction between on-chain and legacy entities through corporate structuring and common-sense legal solutions. Connect on Twitter, LinkedIn, or at lawpanda.eth@gmail.com.