The Myth Of “Canonical” Bundled Bridge Assets — 2008 Financial Parallels
In this blog post, I want to draw parallels between the 2008 financial crisis with the ever increasing incentive for DeFi to create bundled “canonical” assets. DeFi has a problem that is not at all uncommon — what do you do when you have two assets that are tracking (roughly) the same thing but have different origination points / risks?
Currently, DeFi is stuck with isolated risks, with isolated assets. But this is inefficient for protocols — do you really want to spend separate liquidity incentives on USDC.axl, USDC.wormhole, USDC.layerzero, etc. to generate separate stand alone markets for each different bridge?
The variety in bridge providers ultimately creates fractured liquidity, creating a worse trading experience and high expenses for protocols to attract said liquidity.
Thus, the tempation to bundle. What if users could deposit USDC.axl, USDC.wormhole, USDC.layerzero, and receive a “foiled” or “cannonical” USDC? This USDC would be redeemable for any of the underlying assets that are accepted as deposits.
Before I transition to talking about the specific lurking risks of this configuration, I’d like for us to return to 2008.
Bundling risk ratings played a significant role in the 2008 financial crisis, particularly in the context of mortgage-backed securities (MBS) and collateralized debt obligations (CDOs). This crisis had complex and interconnected causes, but the bundling of risk ratings was a crucial factor. Here’s a breakdown of how this contributed to the crisis:
- Mortgage-backed securities (MBS) and collateralized debt obligations (CDOs): To understand the issue, it’s essential to know how these financial instruments worked. MBS were created by pooling thousands of individual mortgages together, and these pools were then divided into securities with different risk profiles. CDOs, on the other hand, bundled various MBS into more complex instruments, further diversifying and repackaging risk.
- Credit rating agencies: Credit rating agencies like Moody’s, Standard & Poor’s, and Fitch were responsible for evaluating and assigning risk ratings to these MBS and CDOs. These agencies played a crucial role in the financial system by assessing the creditworthiness of these complex financial products.
- Flawed risk assessment: The problem arose when credit rating agencies assigned high credit ratings to MBS and CDOs, even though many of the underlying mortgages were subprime or high-risk loans. These high ratings suggested that these securities were very safe investments, which attracted a broad range of investors, including pension funds, banks, and other financial institutions.
- Misaligned incentives: One key issue was the incentive structure within the credit rating agencies. These agencies were often paid by the very institutions whose products they were rating, which created a conflict of interest. To maintain and increase their business with these institutions, rating agencies may have felt pressured to assign favorable ratings.
- Underestimation of risk: Investors relied heavily on these high credit ratings to make investment decisions, assuming that the risk was lower than it actually was. As a result, many institutional investors purchased MBS and CDOs without fully understanding the underlying risk associated with subprime mortgages.
- Widespread investments: MBS and CDOs were widely held throughout the financial system, and the erroneous ratings created a false sense of security. When the housing market began to decline, the high-risk nature of the underlying mortgages became apparent, causing widespread losses.
- Liquidity crisis and market panic: As the true risks of these securities became evident, the market for MBS and CDOs froze, and investors began to panic. Financial institutions that held these securities experienced massive write-downs and faced severe liquidity problems, leading to a series of high-profile collapses and government interventions, such as the bailout of institutions like Bear Stearns and Lehman Brothers.
In summary, the bundling of risk ratings, combined with a flawed rating process and misaligned incentives within credit rating agencies, led to a situation where investors vastly underestimated the risks associated with MBS and CDOs. This misperception of risk contributed to the 2008 financial crisis, as the subsequent market panic and widespread losses had a cascading effect on the global financial system, resulting in one of the most severe financial crises in recent history.
Recently, we are seeing two different DeFi protocols heading towards bundling (renamed under the term “alloyed assets” or “canonical”) — Lido & Osmosis.
Let me requote from earlier: “MBS were created by pooling thousands of individual mortgages together, and these pools were then divided into securities with different risk profiles.” In DeFi, we are taking it a step further — we are bundling assets and choosing to not price them any differently. This is because DeFi does not have objective risk measurement framework for bridges.
This lack of nuanced risk measurement introduces an immense amount of risk because alloyed assets make the explicit assumption that all of the underlying bridges are and will be safe into perpetuity.
The above matrix tell a simple story: if you can perfectly measure risk and you assume every additional bridge added has the same chance of failure, then the more bridges added to a wrapper the greater the chance of exploit. Because trust in pegged assets is dependent on solvency, anything short of 100% solvency will result in a run on the bank. This is what the story of stablecoin crashes have taught us — staking derivatives are no different.
I would posit it is safer to trust a single bridge with 100% of liquidity than to combine multiple bridges into a parent asset under the guise that “one exploit won’t bring the entire asset down”. Liquidity crunches and 2008 have taught us there is a high degree of risk in this assumption. Add to the complexity that DeFi does not know how to objectively measure bridge & smart contract risk means we are operating exceptionally blind when bundling risks.
In summary, alloyed / combined assets have the following advantages:
- Less expensive for protocols to attract liquidity
- Simpler user experience on platforms — only have to deal with one asset
- Easier to onboard liquidity to a simplified experience
Disadvantages:
- Additional solvency risk for each n assets that are added to the foil
I pray that we would all take this risks seriously — lest we lead retail users into holding a “canonical” or “alloyed” asset (perceived as “safe”) that is in fact carrying additional risk in a non-trivial fashion.
-Carter Woetzel (Shade Protocol Lead Researcher)
