CDOs.
There’s a high chance that you watched The Big Short. There’s a scene where Mark Baum, a financial professional disgusted by the system, talks to a CDO manager. In that conversation, Mark finds out that CDOs are even worse than mortgage-backed securities.
Mark Baum realizes how bad the situation is.
Before that scene, there’s another one where the world-famous chef Anthony Bourdain explains what a CDO is by comparing it to a soup made of not-so-fresh ingredients. In the movie context, the explanation is fitting. However, I think a CDO as a tool isn’t necessarily toxic if used responsibly.
CDO means “collateralized debt obligation.” It sounds complicated, but some of you probably created them when borrowing money from platforms like MakerDAO. If you default on your DAI debt, your ETH locked in the protocol is used to pay it off.
During the housing crisis, the issue was bad collateral. CDOs were packaged from all sorts of things, including other CDOs. The effect of such reckless behavior is also explained in The Big Short by Richard Thaler and Selena Gomes. In short, CDOs with bad collateral failed like a house of cards.
In situations where the collateral is managed well, CDOs can serve as a productive tool to enable better risk management. In short, they let people and organizations with different risk profiles have exposure to the same asset class.
Why am I telling you all this? Because I recently encountered a tweet discussing the possibility of CDOs emerging around algorithmic stablecoins, which have been recently gaining the market’s attention.
Algorithmic stablecoins provide access to yield, as we can see with UST, and the trend for offering high yield seems to be just getting started. You may want to access some of that yield but not risk too much. That’s where CDOs can help: investors with higher risk tolerance take higher risk for a higher portion of the overall reward, while you take lower APY, but also less risk.
When I first encountered projects that focused on repackaging risk, I was excited. I wrote a DeFi Spotlight for CryptoBriefing about BarnBridge and spoke with the team. I thought that we were on the verge of DeFi going into pro-mode. But these projects didn’t take off.
Maybe the algorithmic stablecoin trend will revive the trend for tokenizing and redistributing risk. Projects like Saffron and BarnBridge may benefit from that. However, if that were the case, wouldn’t it become the toxic house of cards like in 2007?
Our former Head of Research, Ilya, wrote a great article titled “Are CDPs the new CDOs?” exploring the parallels between DeFi and the mortgage bond market during the Great Recession of 2007-09. Among the concerns about the market, he stated, was the packaging together of assets with different risk profiles, leverage, and misunderstanding of how the system works by investors.
I believe that what Ilya said back in 2019 is even more relevant today. People love to leverage stablecoins to get the maximum possible return while farming. Package these leveraged positions into CDOs, and you have an atomic bomb for the market.
At least, with the on-chain CDOs, you’ll be able to see what’s in them and measure risk accordingly. I hope that will make garbage ones unpopular, and we don’t have something like this too often.
SIMETRI Portfolio: Sideways
As BTC moves around $40,000, the portfolio is also moving sideways. Until the market makes a strong directional move, there’s little reason to expect something much different.
