Dharma Markets Report #2: Shorting in DeFi
By: Max Bronstein
Tags: Blockchain, Ethereum, Finance, Blockchain Technology, Decentralization

Short selling is a crucial component to any well-functioning market — it gives market participants a way of expressing a negative view, leading to more liquidity, additional hedging avenues, and most importantly, more efficient price discovery. In this way, shorting plays a particularly important role in dampening irrationally exuberant asset bubbles.

Using Bitcoin — and the crypto capital markets more broadly — as an example, the effects of short selling are clear. While investors had the ability to short Bitcoin for a few years prior, it wasn’t until 2018 that exchanges made short selling much more accessible. This was likely a result of the competitive pressure created by the CBOE and CME futures launches.

Before more short-selling avenues were available, the primary crypto-asset investing strategy was ‘buy and hold.’ In this system, skeptical investors had no way to participate in the market, which contributed to asset prices losing sight of reality.

Short-selling also provides a monetary incentive for investors to unearth assets that are grossly-overvalued, something that is generally beneficial to the market. For example, it was short sellers who were the first to realize that something fishy was happening with Enron.

Similarly, Tetras Capital was one of the first active funds to conduct deep diligence on ETH, persuasively arguing that its price had outstripped its current value given the technical risks presented in the roadmap and the excessive leverage created by the ICO bubble.

Given the the integral role that short selling plays in traditional markets, it’s important that this mechanism is enabled in the decentralized financial system being built on Ethereum. Fortunately, a number of trustless lending platforms already enable short selling — setting the stage for more liquidity and better price discovery within the Ethereum ecosystem.

What is a short sell?

To better understand short selling, let’s review exactly why an investor would want to short, and how such an investor would execute this strategy.

Short selling is most often used by investors as a way to capitalize on an asset that they think is going to decline in value. Instead of sitting on the sidelines, waiting for the price to drop, investors can take advantage of market mispricings by selling the underlying asset before they actually own it, and then buying it back at a lower price. In order to sell the asset before you own it, you must borrow it.

Remember that the investor doesn’t want to actually own the asset because it’s overvalued. Instead, they want to acquire it for the sole purpose of getting exposure to its price decline.

To acquire the asset, an investor must first borrow it from a willing lender. This can be done through a broker or in a peer to peer manner. As with any loan, the investor must repay the debt at a defined point in time plus any agreed upon interest. Once the investor acquires the asset, they sell it on the open market for the asset that their debt is denominated in, most often a fiat currency. The investor then waits for the price to drop to what they deem is a fair value. At this point, the investor would buy back the asset and repay the loan, keeping with them the profit from the price decline. The act of purchasing the asset back to repay the loan is commonly referred to as ‘covering a short.’

This all works out well for the investor if they accurately predict a price decline, but remember, they have to take out a loan to initiate their position, so a move in the opposite direction can push them deep underwater. In the event that the asset rises in price, the investor is forced to buy it back at a higher price than when they sold it for, and therefore when they repay their debt, they will have actually lost money in the full transaction. Sometimes, a heavily shorted asset that rises in price forces a number of short sellers to simultaneously close their positions. All of the short-sellers simultaneously buying back the asset in order to repay their loans leads to a rapid price increase, commonly referred to as a ‘short squeeze.’

Short selling in DeFi

Short selling is dependent on the ability to easily borrow and lend assets. As we’ve previously discussed, crypto debt markets happen to be one of the largest and fastest growing use cases today, making short selling in DeFi very accessible.

The most popular avenues for shorting Ethereum based assets are Dharma Lever, dY/dX, and Compound. While dY/dX is a popular avenue for shorting ETH, an interesting aspect about their platform is that smart contracts custody the user’s loan at all times, meaning an investor can’t actually move borrowed assets to a different exchange. While this results in an easily-tradable token, investors lose the freedom to choose the best exchange rate. It’s also important to note that while Maker is the most popular platform for getting leverage, it doesn’t currently accommodate short selling as users can only borrow DAI, not ETH itself.

To illustrate how to execute a short sell through DeFi protocols, let’s run through a quick example of short selling ETH through Dharma Lever.

Select an asset you want to borrow (ETH)

2. Specify an amount you want to borrow

3. Deposit your collateral to the Lever smart contract

4. Receive the principal in minutes!

5. Send the principal to an exchange and trade it for USDC or DAI

6. Repay your loan after a price decline

7. Enjoy your profits!

ETH Locked in DeFi: 1/21/19–02/03/19

The amount of ETH locked in DeFi saw a mild uptick over the last two weeks. Uniswap continued its steady growth on the back of the Donut experiment, dYdX saw a mild drop off as volatility dampened, Compound experienced mild withdrawals from their capital pools, the infamous house elections market closed on Augur, and Maker surpassed the 2 million locked ETH mark, huge congrats to the Maker team!

Maker saw a modest increase in the amount of ETH locked in their smart contracts, but the big milestone was the 2 million ETH threshold. Maker now holds 92.79% of all WETH and 1.92% of the entire ETH supply, totalling to roughly $215,000,000 USD worth of ETH backing $76,000,000 worth of DAI.