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The Three Arrows Capital crisis has shown the answer is more DeFi, not less

Transparency allows markets to weed out the good from the bad.

Transparency allows markets to weed out the good from the bad. Whilst it doesn’t necessarily stop bad things from happening, it does allow market scrutiny and therefore a more accurate pricing of risk thus enabling more efficient markets.

Luna provides a stark reminder of how brutal this process can be. The promise of above-average returns and an army of influencers marketing the protocol drove fomo-induced investment from all corners. The broken business model was there for all to see, they just chose not to.

Fascinatingly, Terra’s success was fueled to a large extent by well established crypto institutions and funds which should have been better informed, and were certainly sufficiently well resourced to have done the required homework.

While the market did its job in exposing this flawed business model, the Luna disaster also shows why many market participants prefer not to subject themselves to market discipline. Since Terra’s collapse, we’ve seen many more examples of opaque, centralized practices coming unstuck.

The crux of the problem lies in the divergence between centralized and decentralized funds, and what this means for market participants. Centralized crypto funds operate in relative obscurity, with little to no market oversight or real-time auditability. This “black box” means that market participants can’t see where, when and how these funds are invested or leveraged.

A decentralized fund, however, offers market participants a radically different perspective. These fund models are based on collective auditability, transparency and real-time oversight. Anyone, anywhere can audit and analyze these funds from inception to present day.

In this blog post, we reflect on what the last few weeks could have looked like if some of these more established players had been more transparent, by fully leveraging DeFi infrastructures (like Enzyme) to manage their assets.

  • Would the elevated scrutiny have prevented some of the reckless decisions they’re now being punished for?
  • Would greater market discipline sooner incentivized behaviors which would have been more long-term viable?
  • Might firms have been forced to act more quickly to mitigate risks and would this ultimately have saved investors from being wiped out?

We think so, and below we’ll explain why.

The problem isn’t “too much defi”. The problem is not-enough.

Before we begin, yes I am biased. In 2016, I co-founded the first decentralized asset management protocol, at the time known as Melon and later rebranded to Enzyme.

My drive comes from having experienced my own frustrations in traditional asset management in a previous life. The operational, risk and administrative work around running a fund in CeFi is brutally burdensome and it’s no surprise that risks get missed within such opaque systems.

It might surprise you to learn that in my journey to build, I’ve never set out to disrupt the asset management industry. What I’ve been focused on all along is automating the way existing asset management protocols are enforced.

This involves building a system that elevates the asset management experience into one of empowerment through non-custodial interactions, transparency via on-chain reporting and security via enforceable and automatable risk management within decentralized governance frameworks.

The Luna collapse unveiled an ugly truth. Not only were leverage levels really high amongst crypto players involved, but risk disclosures and management were poorly handled.

Rumors had been circulating in the market for weeks that Celsius was struggling to meet withdrawals from its platform. This was eventually confirmed last Monday when they froze withdrawals on their platform and they were thus declared insolvent. That same day, Binance froze withdrawals from their exchange for a few hours although resumed them later in the day spurring speculation as to whether they were also facing issues.

If you know yourself but not the enemy, for every victory gained you will also suffer a defeat — Sun Zhu, the Art of War.

Whilst all eyes were on this, the market failed to see a potentially bigger victim looming, one nobody expected. Singapore-based crypto hedge fund Three Arrows Capital (3AC) was one of the largest investors in Luna and suffered large losses on the back of the collapse.

Last Friday, it failed to meet margin calls from lenders which took the market much more by surprise. A quick google search shows that 3AC is registered under MAS as a Registered Fund Management company, only permitted to serve up to 30 clients and manage assets of not more than $250m.

The FT reported on Friday that assets held by 3AC were suspected to be anywhere between $4–10bn. Assuming the fund structure was as we think, that would have meant they were leveraged somewhere between 16–40x. Did 3AC realize this at the time? Did their investors, clients and counterparties realize this? Did MAS have any idea?

As DeFi yields contract, they are now for the first time in a while lower than yields on US treasury T-bills. This has led people to speculate around whether DeFi is dead.

DeFi innovation has never been about yield farming for us. The real innovation is that DeFi is changing “how” finance is being done thus enabling higher market discipline. Could the bloodbath of the last few weeks have been better mitigated by DeFi? Let’s take a look at a few DeFi characteristics and how they could have led to different outcomes.

Transparency vs Opacity

Transparency allows market participants to better discriminate good from bad practices, which is essential to regulate and maintain a healthy market. DeFi’s value proposition is fundamentally based on the principle of transparency.

Opacity, on the other hand, obscures hard truths and blinds the market from what is really going on. CeFi funds are by nature far more opaque, which opens up the possibility for bad actors, bad decisions and excessive greed.

In the context of 3AC, we can start by asking a few simple questions:

  • How informed were players like 3AC about their own internal risks?
  • How informed was the outside world?
  • How informed was the regulator?

The MAS regulations do not actually prescribe any restrictions on the investments or use of leverage in respect of a hedge fund offered on a private placement basis in Singapore. This means that players like 3AC in the ecosystem had potentially no obligation to stick to any risk limits and no major reporting obligations.

Assuming these sorts of funds were not required to report to investors, how tight were their own internal controls and information? It’s no secret that traditional fund administrators struggle to produce NAVs for crypto funds that run in a centralized way, but for those funds that are also interacting with DeFi it is close to impossible. It’s hard to measure risk in DeFi because you can’t get a holistic view of your portfolio from a bunch of disparate sources when managing your DeFi off-chain.

  • Did 3AC really have a clear picture of where they stood in terms of risk, leverage, outstanding positions, liquidity?
  • Did they have any risk management controls in place?
  • What was their internal and external (if any) reporting like?

Let’s imagine they did have investors. How could things have been different if, from the outset, they ran everything completely on-chain with real-time reporting, historical on-chain audits and financial metrics to give them risk snapshots? Ironically, there is one central place to look that contains all this data, and that’s the blockchain. Would investors have pushed back on some of the risks had they known? Would the founders themselves have been more conservative had they been more aware? Would treasury managers have still entrusted their treasuries with the promise of 8% guaranteed interest rates? Would lending lines still have been open to 3AC? And if not, would leverage have even been so high in the first place?

Key takeaway: Transparency would have allowed the market to better discriminate good from bad practices, effectively regulating much of the activity that was going on and mitigating a lot of the end damage. This argument supports the fact that decentralized, transparent on-chain funds could actually be much more secure than opaque CeFi funds.

Non-Custodial vs Custodial

One of the more disturbing aspects from the past few weeks has been the halting of user withdrawals. Imagine being an investor who is now locked-in indefinitely with no visibility. There is nothing you can do about it because you’ve entrusted the counter party custodially.

Had those assets been truly DeFi, as in an on-chain fund, this wouldn’t be the case.

For example, let’s assume you were invested in a DeFi strategy that was exposed to UST during the crash. You could have immediately opted to redeem before any of the follow-on repercussions hit. Why? Because you are in control of your own assets in DeFi.

Key takeaway: Centralized funds and companies have ultimate authority to block, halt or deny access to a user’s investments. In true DeFi, the sovereignty of the individual is protected, meaning you have access to your funds in the vast majority of situations.

Decentralization and Trustlessness

Whilst UST claimed to be decentralized, its stabilization mechanism was managed by The Luna Guard Foundation (LFG). The LFG claimed that it raised a war chest of funds ($3.5bn) in order to stabilize Terra if its peg was ever attacked. When that happened , they decided to lend a portion of these funds out to an unnamed and centralized market maker. There has never been any kind of statement on where these funds ended up or how they were used. Once they left the UST foundation and the UST ecosystem, things became opaque. Many suspect they were never used as intended.

Had the funds been managed in a more decentralized and transparent way, could any conflicts of interest have been challenged? Might things have turned out differently? Had there been a way to enforce the trustless expenditure of the funds as intended, like there is on Enzyme, would we be in a different place today? The promise of this war chest kept people hanging on whilst others were jumping ship. The lack of real decentralized decision making here may have been what led to poor or panicked decision making that ultimately became the demise of UST.

Key takeaway: Fear, greed, corruption or conflicts of interest can play into poor decision making and introduce single points of failure. By having robust decentralized governance systems in place, you should be able to sanity check decisions and protect stakeholders interest.

The themes we’ve talked about — transparency, ownership of one’s assets, decentralization — are the foundational philosophies of DeFi.

Embracing them wouldn’t have saved Terra, because Terra was a fundamentally flawed project. But let’s be clear. Things may have worked out very differently for 3AC, and others, had these players embraced the foundational principles of DeFi.

Terra shows why organizations might not want the radical transparency defi offers. The situation at 3AC shows why it is necessary. Ironically, weeks before this all happened CelsiusX had started making a huge move to go on-chain in a brave and unique move to give users more transparency and control. Unfortunately, this move might have come a bit too late for them. We hope not.

Nevertheless, in this light, we believe the need to transition from traditional centralized, opaque and custodial norms to decentralized, transparent, and non-custodial ones is more pressing than it has ever been. Indeed, the unique capacity for radical transparency afforded by blockchain technology would allow for a more powerful and efficient scrutiny and discipline than any regulatory regime ever could .

To those who say DeFi is dead, here’s what I say back: DeFi has never had as bright a future as it has today. Look at the way the market is discriminating against Tether in favor of USDC and DAI in times of stress. Transparency works. Though USDC is centralized, it is far more transparent than USDT. DAI, of course, is a truly decentralized, fully transparent and stablecoin with a proven track record of robust decentralized governance, even when stress tested.

The calls for greater regulator involvement might be growing louder by the day, but while we understand the instinct, we disagree with the diagnosis. We need more transparency. Since DeFi is transparency, we don’t need more regulations. We need more DeFi.

Originally published at on June 23, 2022.