Envisioning Capital Recycling in Decentralized Networks

The purpose of this piece is to explore how decentralized PoS networks may be able to utilize idle base layer assets in their ecosystem and potentially support themselves autonomously, even if just on a partial basis. In other words, how might decentralized PoS networks be able to enhance the productivity of their own native underlying assets which, after all, are the lifeblood of their incentive structures? The Ethereum blockchain and MakerDAO network will be used for reference in this piece for illustrative purposes.

What is capital recycling in traditional markets?

The concept of capital recycling first became popular in the real estate investment trust (“REIT”) sector of the traditional marketplace in the early 1990’s. If a REIT traded at a significant discount to net asset value (“NAV”), the implied course of action to (attempt to) create value would be to sell assets and buy back stock or pay down debt (or both) with the proceeds. Capital recycling has since grown to become a common practice among private equity funds, where rather than managers distributing promptly to limited partners the proceeds received from a portfolio company exit or refinancing, managers permitted themselves to retain, or distribute and then recall, these proceeds to make new or follow-on investments with the anticipation of creating additional (future) value for investors. Hence, the term “recycling”.

How might this tie in to decentralized PoS cryptonetworks?

Honest answer? I don’t know. But let’s get creative.

What follows below is hypothetical thought exercise that does not currently exist (yet). Readers are expected to have a basic understanding of Ethereum and the MakerDAO network built atop it. For those that are unfamiliar with MakerDAO, I recommend reading the first part of Vision Hill’s MakerDAO Case Study.

Suppose for illustrative sake that Ethereum’s beacon chain is live, and that a certain portion of the ETH collateral in MakerDAO concurrently gets automatically bonded to the beacon blockchain for validation. While protocols/smart contracts certainly can’t run their own nodes, for purposes of this exercise let’s assume there is an automated (codified) selection process run by MKR holders that enables this ETH collateral to be delegated to an existing validator. Let’s also assume MKR holders vote (for risk management purposes) what proportions of the ETH collateral can become bonded versus what proportions need to be held back in liquid collateral reserves to protect against any delinquent CDPs. The liquid collateral reserves (e.g. the amount of ETH collateral in this example that is not bonded) should be able to sufficiently meet a certain percentage of free-willed CDP redemptions (the amounts of which would likely be determined at the discretion of MKR holders). The incentive for users to enable collateral bonding is to earn more collateral via validation rewards. This can essentially become a margin hedge if done at the right volumes.

What risks get introduced from this?

First, the liquid collateral reserves may become insufficient if the price of ETH collapses, or a suddenly large slew of CDP holders decide to voluntarily close out their positions (or both). Given the beacon chain’s unbonding period may span several days until enough liquidity gets gathered again for distribution, CDP holders may find themselves in a temporary liquidity crunch. In such an event, CDPs can still be closed, but rather than CDP holders (or keepers) gaining possession of ETH collateral (as they do today in SCD), in such a scenario they could gain claims to soon-to-be-received collateral (presumably, user consent would be needed in advance). MCD will likely be adaptive and follow similar suit. Those claims could openly trade on the open market as IOUs at incrementally small discounts (I envision this being similar to the repo rate market). Thus, if one is able to sell that claim for enough Dai to repay the outstanding CDP loan, the CDP can successfully be closed and the ETH collateral will be distributed to the new claim holder. Otherwise, if such a user is unable to sell the claim, that user is left waiting until the beacon chain’s unbonding period lapses to receive the ETH collateral to repay the loan.

While it may be easier (and far less complex) to instead tokenize the bonded beacon chain ETH, enabling top validators to issue tokens representing claims on bonded ETH (a similar approach to Compound V2) that can be used as collateral in the MakerDAO network (essentially reversing the above proposition), this approach does not enable productivity for the existing non-staked collateralized ETH sitting idle in the MakerDAO network.

What happens if there is a fork?

In any event, to protect against the potential risk of weakened security, stake slashing as a result of “offline activity” can be used as a defense mechanism to devalue the forked network’s value and its corresponding artificial collateral. If the forked ETH isn’t bonded over time, it will lose enough value that the wider market consensus is to no longer support the forked network. This is because productive market participants will be able to proportionally grow their network stake over time by collecting a larger proportion of validator rewards at the expense of unproductive market participants.

How would this work in an interoperable world?

With the above risks (illiquidity of collateral and a network partition) potentially addressed, we can now envision a decentralized network that can autonomously support itself, even if just partially. This may spark a new generation of “capital recycling”; the base layer digital asset (ETH) flows up to enable applications (MakerDAO) built atop it, only to then flow back down (albeit partially) to contribute additional base layer support (network security). After all, regardless of whether a network introduces a “money-ness” element or not, the base layer (and the corresponding native digital asset) has to be “valuable enough” to support the applications built atop it. While there is no asset disposal per se (assuming, of course, that there is proper risk management and no flow disruption) as there is in the case of traditional market capital recycling, we can now envision a recycling mechanism whereby decentralized PoS networks are able to enhance not just the productivity of their own native underlying assets, but their overall network health and value as well.

Whether or not this kind of recycling initiative ever comes to fruition in decentralized networks remains to be seen, but enhancing network productivity to enable greater utility value is something that will help this asset class grow as there would be less reliance on speculation. Lastly, while the financial risks of the autonomous recycling mechanism above can likely be calculated with probable certainty, we should not ignore the magnified technical and systemic risks introduced as a result of the substantially larger coding requirements.

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Disclosure: I personally hold positions in BTC and ETH, and indirectly through Vision Hill hold BTC, ETH and MKR. The content provided herein is of my own opinion and should not be considered investment advice, and is not a recommendation of, or an offer to sell or solicitation of an offer to buy, any particular security, strategy, or investment product. I have not received and will not be receiving any compensation as a result of this publication.

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