Composability, and how one default spreads

Graduate · enrolled learners

This lesson opens with The near-collapse of AIG, 2008.

What happened

AIG, one of the world's largest insurers, had through a single unit written enormous volumes of credit default swaps, in effect insurance policies, on mortgage-backed securities and related assets held by banks around the world, promising to pay out if those assets defaulted. This made AIG a central node in the financial web: a great many institutions were protected by AIG and therefore depended on it, so their safety was really AIG's solvency. When the underlying mortgage assets deteriorated in 2008, AIG faced collateral demands and payouts it could not meet, and its failure would not have been contained to AIG; it would have fallen on every counterparty that had relied on its protection, potentially toppling them in turn. To stop that cascade the US government stepped in with support that ultimately totaled around 182 billion dollars, not to save AIG for its own sake but to prevent one node's failure from spreading through everything connected to it. The risk had never been just AIG; it was the web of dependence built on AIG, where one default would have become many, because everyone was composed on the same promise.

The decision point

Composability means parts are built on other parts, one institution or protocol depending on another's token, solvency or promise, and it creates a web in which a heavily-connected node's failure does not stay local: it spreads to everything connected to it, so the risk of any position is the whole web it sits in, not the single node in front of you. AIG is the case: an insurer that had written protection to institutions across the world became a node whose failure would have toppled its many counterparties, forcing a roughly 182 billion dollar rescue not to save it but to stop the cascade. This is the defining risk of DeFi, which is composable by design: protocols build on protocols, a lending market holding another's token, a stablecoin backing a dozen strategies, an oracle feeding every price, so a default in a widely-composed component spreads to everything built on top, and the loss you can suffer is not bounded by the protocol you chose but by every protocol it depends on and every protocol that depends on it. It ties this track together: real-world credit risk comes through the on-chain door (as Maple showed), and composability is how one such default spreads from a single pool to the whole structure, exactly as AIG's mortgage exposure spread through the swap web to the financial system. So the decision when taking a tokenized-finance position is to map its dependencies, what it is built on, what shares its collateral or oracle, what would fail if a common node failed, and to recognize that composing with something means inheriting its failure, because a composable position's risk is the risk of the entire web, and AIG is the proof that one node everyone leaned on can turn a single default into a systemic one.

Recorded loss

$182,000,000,000

Orientation and Year One are open: anyone can read them without an account. From Year Two onward the lessons are for enrolled learners, because progress through the later years only means anything if it is tracked against a record.

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