If decentralized finance were a character in a fable, we could imagine it as a rebel warrior taking on the world — traditional finance in particular. Then we can think about that rebel’s different body parts as composed of the industry’s best projects so far.
So, its two fists might be Uniswap and Curve, the decentralized exchanges that are letting people put their resources behind a lot of ideas and move them around quickly as one fades and another looks promising.
Basic financial products that let people do recognizable financial work but in a decentralized way, like Compound, Synthetix, Cover and dYdX, might be the arms that make our warrior strong. Ethereum itself would be — obviously — the heart, while long term plays — like Yearn, Convex and Index Co-op — might be thought of as the left brain and NFTs and crypto hijinks (like Jay Pegs Auto Mart) as the right brain.
But what are the legs? What are the projects that, if they were to be cut out from under it, would make our metaphorical warrior fall to earth?
Potential Weak Points
Based on crypto leaders The Defiant recently contacted, it seems clear that the legs holding up decentralized finance (DeFi) are two completely centralized products: the fiat-backed tokens, Tether’s stablecoin, USDT, and the stablecoin made by Circle and Coinbase, USDC.
Stablecoins are cryptocurrencies built to maintain a price parity (or a “peg”) with something in the analog world, usually the dollar. The two stablecoins in question do this simply by making new tokens from US dollar deposits and promising to redeem their tokens for bank account dollars if any of their clients ask them to do so.
Beyond the two stablecoins, there’s a variety of other potential weak points in DeFi right now (oracle manipulation, governance attacks, cross-chain contagion), but anyone looking for potential black swans that could rock the $250 billion locked up in this industry should keep an eye on the top stablecoins.
For example, Arjun Bhuptani of the Connext Network sketched out the basic scenario if USDT were to just completely lose its peg due to the longstanding uncertainty about its solvency. Every decentralized exchange pool that held it would fall apart, causing massive losses as folks both rushed to exit their liquidity provider positions and traders attacked them for arbitrage opportunities. Investment protocols, such as Yearn and StakeDAO, that depend on liquidity pools would hemorrhage funds.
“I think in general you should consider something like this, a 2008-financial-crisis-like doomsday scenario,” Bhuptani said in an email. “I see no instance where a situation like this doesn’t cause people to panic and try to exit everything they can ASAP, which, in turn, causes a run on most liquidity/debt in the whole DeFi space.”
But Bhuptani admits these are just guesses. The truth is no one really knows.
“A market crash such as 2017 has no precedent in the DeFi ecosystem yet,” Rafaella Baraldo, co-founder Pods Finance, a hedging platform, wrote in an email. “The closest we have from a crash is March 2020, and by then, the ecosystem was far different from what it is now. On chain usage has increased, and protocols are highly dependent on each other.”
Not everyone was quite so nervous. Michael Feng, CEO of CoinAlpha, which made Hummingbot, the market making platform, wrote in an email that USDC and USDT are just not that dangerous. “Those instruments are relatively simple, collateralized by highly liquid instruments like BTC and USD, and under high scrutiny by regulators,” he wrote. “That’s not where the real risks lie.”
Both stablecoins theoretically face the same dangers: regulatory (authorities crack down or demand censorship of certain users), collateral risk (the assets backing the stablecoin lose value or the public loses faith) and security (either collateral gets stolen or unbacked stablecoins get printed and spent before anyone notices).
But most people worry more about USDT’s solvency and about USDC’s eagerness to comply with the authorities.
If something should go wrong it’s especially scary in crypto because all the technology places extremely high value on finality, that a thing is done once it’s done.
“The issue is that DeFi has no form of recourse — there is no undo button,” Hart Lambur, co-founder of the UMA protocol, which makes synthetic assets and other unique financial products, wrote in an email. “It’s pretty hard (maybe impossible?) to build a system that can scale to trillions in value unless there is some way to ‘undo’ bad things when they happen.”
Imagine our rebel warrior was suddenly forced to fight with a splint on one leg. That might be a rough metaphor for USDC in a time of regulatory aggression.
USDC is the coin of the realm in DeFi. Since around October 2020, it’s been the most popular stablecoin in DeFi by TVL, according to Flipside Crypto.
DeFi’s leaders fear regulators will use the two US-based companies behind USDC to put the screws to DeFi, which they could do. USDC is primarily a Circle project and there’s nothing about the company that suggests it would do anything but roll over for the money cops. Its founder, Jeremy Allaire, has been trying to put cryptocurrency into a business suit since before Circle even launched its first products.
“I think USDC freezing accounts would cripple DeFi because of how many things ultimately trace back to USDC exposure — DAI, base pairs in many LP pools, etc.” Avichal Garg, managing partner of Electric Capital told The Defiant via email.
Freezing funds would not be unprecedented. The question is: will they ever do it at a massive scale?
Centre is the organization that Coinbase and Circle set up to run the product. Jessica Gardner from its business operations team sent The Defiant the following statement:
“Centre’s Access Denial Policy is … designed to comply with a law, regulation, or legal order from governmental authority with jurisdiction over Centre; or under extreme cases where it’s necessary to prevent a threat to the security, integrity, or reliability of the USDC Network.”
Within DeFi, USDC has enormous scale. Take Uniswap, the crossroads of DeFi. USDC is the second largest token on the application, after ETH, with $581M of the $3.9B locked up in the decentralized exchange, as of Nov. 18, but that’s probably not the most important fact about USDC on Uniswap.
USDC is paired with another token in 64 of its pools that have more than $1M in TVL (there are almost 400 pools that have ever had USDC in them and lots more pools with tiny balances).
ETH is paired with many more tokens, of course, with 189 pools that have more than $1M, but the next most liquid token on Uniswap, WBTC, is only in 10 pools with over $1M. USDC also makes up $3.5B of the $18.4B supplied value on Compound, the money market. According to The Defiant Terminal’s data, there is 538.5M USDC in Aave (approximately 4% of the total value locked), 1.38B in Curve (~9%), 2.4B in Maker (~13%), 196M in SushiSwap (~5%) and 776M in Uniswap (~9%), as of Nov. 19.
For a while there, USDC was a major vulnerability for DAI, the most popular decentralized stablecoin. USDC has made up a dauntingly large portion of collateral for DAI ever since March 2020 when MakerDAO was economically exploited and the system briefly had a few million dollars worth of unbacked DAI.
Since early November, though, USDC is now a reasonable 12% of DAI’s underlying collateral, with ETH itself once again making up the lion’s share, according to DAI stats, and WBTC also a healthy portion.
But a failure in confidence in USDC wouldn’t be good for DAI nor any facet of DeFi. and, if USDC ever engenders uncertainty in crypto, it is the most likely to do so by putting law as law before code as law. “Censorship by unforeseen regulation could impact DeFi protocols in a way that we don’t yet understand, ” Baraldo said, echoing a concern brought up by many leaders.
Until the authorities act, there’s no way to know how far they will go and what USDC’s stewards will comply with. It might depend on whether or not regulators demand only that certain suspect wallets get frozen or if they go further, ordering that any USDC that has ever touched a suspect wallet gets frozen. Were that to happen, there could be millions of USDC now sitting in smart contracts that would suddenly no longer be liquid.
“USDC freeze means big chunks of DeFi have USDC that are frozen but no one knows which addresses actually, so everyone tries to get their USDC out which is basically a run on the bank,” Garg said.
Michael Egorov, Curve’s creator, is less concerned about the censorship scenario. “When USDC or USDT are required to do some things for regulatory compliance which impede their use a lot — but they do not lose backing — that probably would still work,” he told The Defiant via email
There’s a long term, softer issue as well. USDC is highly associated with Coinbase. Together, they are seen as the legitimate, regulated, “safe” way to be part of the DeFi world. If USDC becomes seen as unreliable, but makes the normies a lot more guarded about this space for a lot longer.
“This affects the long-term trust of a portion of the mass market. Which reduces demand of crypto and DeFi in the long run” Lisa Jy Tan of Economics Design told The Defiant via email.
Of course anyone’s leg can go out at any time, and USDC could certainly give way like anything can — things fall apart, but many people worry more about Tether actually failing than its rival, a scenario in which one of our imagined warrior’s legs loses all its strength.
Or even just gets chopped off.
There’s a lot of USDT out there too. According to The Defiant Terminal data, there is 183.6M in Aave (approximately 1.4% of TVL), 1.5B in Curve (~9.6%), 413M in Uniswap (~5%) and 97M in SushiSwap (2.6%).
The chief fear about USDT is that all the rumors about its solvency have always been true and finally the market becomes convinced. Tether has constantly been hounded by suspicion that it does not hold nearly enough assets to cover all the Tether, all $73 billion worth, in existence.
In October, it paid $41M to settle a suit by the Commodity Futures Trading Commission over its statements that its tokens are fully backed by fiat-currency.
“I’m pretty worried about the possibility of a major stablecoin de-pegging or being found to be un/undercollateralized. For instance, if there’s a run on USDT, that would likely break most of DeFi,” Connext’s Bhuptani said.
This is not the kind of thing that happens gradually. If it happens, it will happen all at once.
It’s not just DeFi though. USDT’s failure would spread repercussions across every blockchain like fresh cracks in a shattered windshield, because Bitcoin depends on USDT for liquidity. “A big factor in determining whether a failed stablecoin will be an existential crisis or just extremely expensive is how much the price of ETH, BTC and other cryptocurrencies go down,” Kenny White, CEO of Cowri Labs, which makes the Shell Protocol, told The Defiant via email. “My hunch is that a lot of risk modeling underestimates how high this correlation might be.”
Tan, however, did not think there was a lot of doubt here about what would happen: “USDT is highly important to BTC trade. USDT fall = BTC ngmi.”
And as BTC goes, so does the rest of the market.
“First, we should try to define what ‘fail’ means in this context,” White said. “I will describe ‘fail’ as a stablecoin permanently losing its peg. In the most severe case, the stablecoin becomes worthless. There are a variety of ways a stablecoin can fail. If Tether were to fail, at minimum the price of bitcoin, ether and all other crypto currencies would take a huge hit. I also suspect that a few centralized exchanges would be rendered insolvent.”
Tether did not reply to multiple requests for comment from The Defiant.
Extremely Important Protocol
The thing about economies is that everything in them is connected, and in DeFi it’s all connected programmatically. Let’s take a particular case in point, that of Curve, the decentralized exchange that specializes in stablecoins of various kinds.
As we’ve previously reported, Curve is an extremely important protocol to DeFi’s yield seekers. Stablecoins rely on it to drive liquidity. Yield aggregators rely on it for returns. If a major stablecoin tanked, that would hit Curve extremely hard as well as all projects attached to it.
“If USDT were to depeg tomorrow (because, for instance, they found that tether is only 20% collateralized and therefore insolvent), that would cause every USDT-denominated liquidity pool in the space to implode,” Bhuptani said.
Curve has been cleverly designed to be flexible. Curve uses metapools in order to improve liquidity. So, while most pools on Uniswap are pools of two tokens that are only dedicated to that pool, Curve uses composability internally. Many pools on Curve are one token paired with another pool (for stablecoins, that’s the 3-Pool, which holds DAI, USDC and USDT).
So, anything that goes wrong with 3-Pool spreads immediately to lots of other pools.
“Any other Curve pool holding the 3-Pool LP token will also fail. So basically a majority of Curve would fail (unless there is a back door to freeze the pools and halt trading),” White wrote.
Michael Egorov, Curve’s creator, confirmed that an unraveling of any of the big cryptocurrencies would be far reaching. “There is no protection there really. Many pools are dependent on 3-Pool, and if any of the major stables loses the backing forever — this is very bad,” he said via email.
From there it spreads, “What happens if a large majority of Curve’s TVL disappears overnight? Protocols such as Yearn would also probably go insolvent. And of course any protocol with exposure to Yearn would be affected,” White said.
Beyond that though, it gets a lot harder to predict what will happen, Tan explained. The next question: Do people retreat within crypto or out of crypto entirely? If they retreat within crypto, say to other stablecoins, that could cause their prices to become “messy” she said, as demand pushes up the smaller stablecoins’ prices and then the protocols behind them try to drive the price back down during an erratic time.
Central Banks of Crypto
We just don’t know how people and protocols would behave under that kind of stress in this brand new industry.
Then there’s another scenario that one of the chief delegates in MakerDAO governance pointed out to The Defiant.
Every now and then, a central bank gets caught messing with the rate of interest to borrow their fiat currency, PaperImperium told The Defiant. It doesn’t tend to work out, but it happens.
If central banks do it, it’s not impossible to imagine that these central banks of crypto could give in to the same temptation one day.
“If Tether or USDC or DAI decided to suppress market interest rates on their coin, they would eventually be in a position where they would run out of reserves to defend their peg on the open market/redemptions,” PaperImperium wrote via Twitter DM.
“DeFi composability is awesome, but that means each subsequent building block inherits the risk of underlying blocks…”
Here’s how that could work, in a very simple model: If a stablecoin wanted to see more trading volume, it could supply a lot to lending platforms such as Aave, which would push down the cost to borrow it. If they did it enough, there would end up being more of the coin in the market than the market wanted, so it might start to fall below its peg.
Fiat backed stablecoins defend their peg by allowing users to withdraw fiat at the pegged rate. So if, say, USDT did this, and Tether was at $0.97, a big arbitrageur could buy a 10 million USDT and redeem it for USD, clearing an easy $300,000 profit.
The danger here is if they keep pushing the borrowing rate down, they lose collateral. Which would maybe matter or maybe it wouldn’t. After all, if they are behaving correctly, tokens get burned as they get redeemed. Under this scenario, though, the financial controls might have come off.
“I don’t think anyone would be so economically illiterate as to do that. But as I say, central banks try it (and fail) on a fairly regular basis,” PaperImperium wrote.
It’s important to keep the really out there threats in mind but the true dangers are probably simpler: a total depegging or regulators making a play to slam on DeFi’s brakes.
And it’s also worth remembering that crypto works differently than the traditional economy and might behave differently in a crisis. “Crypto is actually more anti-fragile than traditional finance because holders are a lot more decentralized,” Coin Alpha’s Feng said. “Unlike traditional finance where insolvency of the U.S. government would cause huge problems, there are virtually no ‘too big to fail’ institutions.”
Still, one has to keep in mind that DeFi’s applications are hyper-interconnected, and that is why it’s helpful to think of DeFi as one body, as a rebel warrior, albeit with some neat, cutting edge armor and an excellent physique. Nevertheless, it is still all extremely interconnected, like any body, so what hurts one part can create a contagion to the rest.
“DeFi composability is awesome, but that means each subsequent building block inherits the risk of underlying blocks,” Bhuptani said.
Or maybe it’s not the underlying blocks? Maybe it’s the blocks on top. If the two leading fiat-backed stablecoins really are the legs this industry stands atop? Even the most skilled warrior loses their edge when a leg goes.