Here on Publish0x I often see articles about various De-Fi things. And when I read yet another note about e.g. lending ETH and borrowing DAI, I can't help thinking about so-called repo deals.
Wikipedia has an article about repo deals. You probably find even more info in Alexander/Beily/Sharpe's "Investments" or in a similar book. Shortly, a repo deal (or rather, one of its types) is when you borrow money using your securities (say, bonds) as collateral, then make some profit out of that money, and then pay your loan back and take your collateral. In other words, you "sell" your bonds temporarily and then "buy" them back after some time. I hope you got the idea because at this point I already exhausted my English superpowers...
"So what is here about De-Fi?", you might ask.
Let's take one popular scenario.
You have some ETH. You go to a De-Fi app and borrow some DAI using your ETH as collateral. Then a) you can lend that DAI out at another De-Fi app, or send them to Celsius account, etc, to earn some interest, or b) you can buy even more ETH for those DAI. If it's the case b), then you might go to the first De-Fi app and lend that newly bought ETH for DAI too. Then you might buy even more ETH. And so on. I again hope you got the idea -- it is building a leveraged pyramid.
Of course, this building process can't last forever -- because of collateralization ratio. If you have $100 of ETH -- one can hardly lend you $150 of DAI. He'd rather give you the same $100 of DAI at best. Or more probably -- only $80 of DAI, maintaining the collateralization ratio of 1:0.8 Thus he feels more secure if ETH price goes down and your $100 of ETH becomes, say, $95. If ETH price goes even lower, your lender will either ask you to add more ETH to your collateral or will sell your ETH he holds to get his DAI back, that is -- you get a margin call.
And this margin call thing is the funniest part!
When the price of collateral security starts falling sharply, borrowers have no time to increase their collateral and it goes liquidated/sold (on modern exchanges it's done automatically, by bots and alike), pushing the price even lower and triggering even more margin calls. Sometimes it looks like an avalanche, a single sharp price move triggers a margin call for some poorly collateralized repo -- and then all those leveraged pyramids start to fall!
Why I'm talking all this? Long ago, in 2008, at some local stock market, I've seen such an avalanche of falling leveraged repo pyramids, in real-time. It's a fascinating show, I dare say! Within seconds price falls down like 10-20% smashing all buy orders on the way, before the exchange stalls operations trying to normalize the situation. Also, it was a very profitable time if you knew how to short the right papers.
Today I read articles that say how profitable a leveraged DeFi pyramid is. Yup, indeed, in a bull cycle.
Well, is it really possible and probable that those DeFi things fall down like an avalanche?
From what I know about De-Fi lending, and namely about ETH/DAI and similar games -- yup, I think it's possible.
However, I don't know how probable this scenario is. Normally, DeFi's ETH/DAI collateralization ratio is pretty high, like 1:1.5 or even 1:2. That is, to get a margin call, the price of the collateral (ETH) must fall really quickly and low, which doesn't look very probable at the moment. However, with multi-collateral DAO the situation may become different. Besides, Mr. Taleb tells us that sometimes sh*t happens more often than it could be expected statistically.
The actual thing I want to know is how I could short ETH against DAI.