Analyze DeFi economic incentives and risks: stablecoins, governance and DEX, etc .
Think about the risk structure behind the rise of DeFi, stablecoins, lending agreements, decentralized exchanges and other fields. Original title: "5 Big Risks DeFi Got to know! 》 Published by: Ariah Klages-Mundt Translation: Jing Kai More individuals began to pay attention to the main topics DeFi governance. The memory of "Black Thursday" throughout the collapse of the crypto market in March in 2010 in addition has intensified people's concerns about DeFi. Folks are focused on the lack of understanding of the chance structure of DeFi. In this article, we're mainly centered on the stable currency field, but similar thinking could be applied to many broader fields of encrypted economic systems, including cross-chain protocols, home loans, and decentralized exchanges (DEX). We think that in certain DeFi systems fashioned with extensive governance power with no social recourse, the participation of rational subjects could be zero. It is because the price of adjusting incentives in these systems could be prohibitively high (this is similar to requiring banks to have a long-term P/E ratio of just one, 000 to ensure depositors' funds are not stolen). Our framework provides a solution to model these systems and generates some unanswered research questions which will be the main element to the development of DeFi. Certainly one of Compound's recent hot news in the DeFi field is the issuance of Compound's COMP token, which has develop into a leveraged risk circus. Driven by the reward mechanism, users have played a crazy game of leverage. As you can plainly see on the Ethereum network, all this is going on. Traders conduct COMP liquidity mining (Yield Farming) by maintaining complex multiple positions: for example , depositing ETH and USDC, lending a lot of BAT tokens; then, re-depositing BAT to a new Compound account to borrow ZRX tokens out, then deposit ZRX to the previous account, lend more BAT tokens, etc . (Translator's Note: Yield Farming, which means that token holders deposit funds on the platform, provide liquidity for the platform, and acquire the token incentives supplied by the platform, that is mining for liquidity) May very well not have looked at this type of operation before, but do not think about any of it due to this article: God operation, I will try it too! We have been obliged to emphasize that type of operation accumulates the risks of layers of leverage, especially in low-liquid markets such as for example BAT and ZRX. The risks involved are worthy of your personal analysis and analysis. Look at the multiple liquidations on Black Thursday! This low-liquid market is simple to govern and an easy task to attack. The others can use this to trigger the liquidation process and benefit from your losses.
Using high-risk assets for "Yield farming" is very dangerous and an easy task to hang. Don't add user funds to BAT liquidity mining with high leverage. Everybody, have a snack! If its goal is always to increase audience coverage, then a release of COMP is without a doubt successful. What's more obvious is that Compound has temporarily increased liquidity gains and solved the problem of "the chicken or the egg" when using the platform. Ironically, it sets up a platform for large-scale stress testing. In several reports, few people talked about Compond's initial goal: to foster "an increasingly large ecosystem [... ] could have the motivation to control the ongoing future of the agreement with good governance. " The distribution of COMP tokens is actually to achieve a wider distribution of governance rights among platform users, to ensure that users can manage their particular security. How to design a motivation mechanism to align the interests of participants is really a broader issue in the whole encrypted economy system. Using stablecoins as the background of analysis, we've created a framework to quantify the incentive problem. This framework could be widely applied to encrypted economic systems. We put forward a simple question of incentive security in the device: [Incentive security] After thinking about the attack situation, can all parties continue steadily to participate, can they nevertheless be mutually beneficial? If not, then a system won't work as the equilibrium participation is zero. Like if the incentive mechanism makes the attack profitable, then rational participants will price this risk when determining their education of participation. Only after answering this question can we comprehend the question of economic stability. [Economic stability] Can the incentive measures in the device produce stable results? May be the incentive mechanism sustainable? From the perspective of the model we've constructed, as the scale of the device expands, just how to provide continuous security incentives to combat governance attacks? This question is important. If the return on the attack is greater than the price of the attack, then it really is profitable to govern the attack. The reward is proportional to the worthiness of the assets locked in the device (AUM): if the governance power is strong, the collateral could be directly stolen (and the related liquidity pool on the DEX is cleared); even though the governance power is not so strong, the collateral assets can nevertheless be stolen indirectly, By manipulating parameters and preventing users from exiting, it may succeed even though there's a time delay in governance. The price of the attacker includes the worthiness of the governance token. For the "honest" governor, the fundamental value of the governance token value arises from the provision of future governance fees and institutional responsibilities (such as legal recourse). Stablecoins, synthetic assets and cross-chain assets For noncustodial stablecoins (as well as synthetic assets that use similar mechanisms and cross-chain assets of BTC), the worthiness of security governance has to exceed the worthiness of locked assets, which is a certain multiple of the latter Numerical value. When contemplating the long-term equilibrium with moderate growth expectations as time goes on, the problem of scale is going to be reflected. In cases like this, today's value of future expenses (even the unrealistically high proportion of AUM, that's, the worthiness of the assets locked in the system) can't Reach the level of AUM multiples. In cases like this, the security of the decentralized governance system depends on the device participants holding governance tokens holding numerous governance tokens in order to enhance its market value. This may feed back into the incentives of those other parties to participate, and there's absolutely no guarantee for the existence of balanced participation. Like in order to ensure their stable positions, stablecoin holders might need to hold numerous risk management assets, that might violate their intent behind holding stablecoins. This led us to an informal conjecture (and also an important direction for future research! ). [Conjecture] In several DeFi systems fashioned with extensive governance rights with no social recourse, the participation of rational people could be zero in equilibrium. The point is that the price of adjusting incentives for participants in these systems could be prohibitively high. Let's just take the bank's situation as an analogy: in case a secure incentive mechanism is implemented, the bank's currency markets value must certanly be a multiple of the total deposits, so it is maybe not worthwhile for depositors to participate. Put simply, the bank's long-term P/E ratio has to reach about 1000 (and supported by depositors) to ensure the bank does not steal depositors' funds. The clear answer currently implemented is simply centralized governance. This solution relies on a form of institutional responsibility, which is often described in our model. This example does not fundamentally cause problems. In fact , many conventional financial systems operate this way. This is the reason the worthiness of the bank doesn't need to be repeatedly the total deposit. Nevertheless , we have to publicly acknowledge that type of trust could be essential. Solving these problems in a totally decentralized manner continues to be a challenge to be solved. Decentralized exchange (DEX) incentive models will also be meaningful for some DEX. Like in case a DEX runs its own independent blockchain (this chain is jointly controlled by the DEX governor), when an attack does occur, the governor can restrict users who provide liquidity to the platform, making them struggling to withdraw, even in governance This is especially valid if you have an occasion delay. In DEX, fee accrual ("honest" governance profit) is proportional to a percentage of the total transaction volume over some time, which may be many times the instantaneous AUM value of the exchange, and the safety of incentives continues to be associated with AUM. For Uniswap, the annualized transaction volume could be about 100 times the deposit. In comparison, the accrual fees generated by the stablecoin system could be about 1/4 of the deposit supply. Weighed against stablecoins, the governance accrued fees of DEX could be much smaller, but this factor around 400 times makes the feasible area of incentive security for governance attacks in DEX could be larger. This leads us to the following informal conjectures to compare the feasibility of different types of DeFi applications. [Conjecture] Weighed against stablecoins, DEX is easier in order to avoid governance attacks from an economic perspective. Considering these possibilities, when designing DeFi services and products, the research of common incentive mechanisms is a lot more essential. With your preliminary discussions on loan agreements, let us return to home loan agreements, such as for example Compound. These have the same structure to noncustodial stablecoins. Nevertheless , they truly are slightly simpler because borrowed assets are largely exogenous. As a result of this exogeneity, participants could be more likely to exit the device ahead of the governance attack is successful (that is, throughout the governance time delay). Like consider that the borrowed asset is USDC; in cases like this, the vault can deleverage and exit whenever you want through the issuer creating new stablecoins at face value (specifically, once they wish to withdraw, they don't depend on Dai holders to sell Dai back again to them). Essentially, governance delay in this environment is really a more powerful preventive tool, but if it involves an elaborate price feed mechanism and/or an attack where miners can extract value, there could be exceptions. This means that some small market capitalization assets in Compound can start to deviate from the exogenous situation. The BAT and ZRX markets are basically overutilized because they are currently conducive to liquid mining. Like the use rate of BAT is currently 91%, the nominal value of BAT deposited at present is 234 million, and the total market value of BAT is 377 million (although this section of BAT could have a certain net value because it arises from multiple borrowings, and then BAT is deposited repeatedly). Because of the structure, the large-scale liquidation of BAT could have a deleveraging effect just like that of a well balanced currency, that will be discussed further below. Data from Compound on June 23, 2020 One question remains: In the long run, does the distribution means of COMP tokens help motivate users to align their interests? Put simply, did it reduce user costs when resisting governance attacks? At first, this looks promising. Users get governance shares through participation, so they really need not consciously raise the governance market value in order to protect the security of the system-they just won't need to sell the COMP shares they get. But once users receive shares, which become section of their investment portfolio, they are going to choose whether to maintain this risky position. Although the distribution of COMP has undoubtedly attracted many new users to the Compound platform, it really is still as yet not known perhaps the distribution mechanism of COMP (or every other distribution mechanism) will help the device achieve a far more stable governance balance. Stablecoin: Design, Model and Risk Below we start from several typical forms of stablecoin and describe the risks and trade-off dimensions of different functional components. The big difference between custodial stablecoins and noncustodial stablecoins is obvious. The former relies on some sort of trust in an authorized, as the intent behind the latter is always to de-trust. The figure summarizes and analyzes the stablecoin design based on some of the most essential risk dimensions Custodian stablecoins In terms of custodial stablecoins, you can find three different types of stablecoins. They all are anchored through the task of arbitrageurs, who is able to create/redeem stablecoins for the topic matter. The reserve fund of stablecoins maintains a reserve ratio of 100%, just as the ETF of USD on the blockchain. These include TUSD, USDC, and later iterations of Libra. The second type, including Tether, resembles a bank or money market fund, with a partial reserve mechanism. This type of stable currency faces the chance of de-anchorage just like bank operations. In October 2018, this case occurred in the Tether stablecoin (USDT). When its partner exchange Bitfinex suspended the USDT exchange for legal currency, the crisis of Tether followed. As funds flowed from Tether to assets with less credit risk, the currency's anchor to the U. S. dollar was broken and arbitrage occurred. The writer was struggling to re-anchor Tether to the united states dollar. We've noticed that in contrast to conventional banks, these "banks" like Tether could be less regulated and audited, and may not need government guarantees and can't handle bank runs. In October 2018, Tether was off anchor from the U. S. dollar The third kind of stable currency is directly issued by the central bank. Currently, the central bank only provides reserve deposits to commercial banks, as the CBDC's goal is always to provide consumer-oriented deposits, possibly in the form of tokens. These custodial stablecoins face risks just like those of conventional financial systems. These risks mainly originate from counterparty risks, such as the danger of custodians breaching their contract to fulfill their linked value obligations. A related risk is the review risk, that's, the custodian selectively chooses which claims to honor. The characteristic of noncustodial stablecoins is that it no further depends on specific custodians like custodial stablecoins. What replaces these social institutions is the economic structure, which establishes an economic climate between participants through smart contracts. noncustodial stablecoins are similar in structure to dynamic versions of risk transfer tools, such as for example collateralized debt certificates (CDO). CDO is supported by way of a pool of mortgage assets and divided into different credit tranches. When there is a loss, the low-level credit tiers absorb losing first, and after every one of the low-level credit tiers are paid off, the high-level credit tiers absorb losing. Within our research paper, we provide a broad idea that can decompose the look of all noncustodial stablecoins to the following functional components. The following figure draws the look of several stablecoins and describes how they truly are associated with one another in the form of some components.
* Main value objects. The economic structure of the stablecoin value basis mainly arises from market expectations under a certain system. Divided in to three types.
* Exogenous collateral: As well as the stable currency system, collateral has other uses, such as for example ETH in Maker. * Endogenous collateral: The goal of creating collateral is always to serve as the subject of collateral for stablecoins. * Implicit collateral: In cases like this, rather than using explicit collateral, market mechanisms are accustomed to dynamically adjust supply to stabilize prices. This really is just like endogenous collateral, but you can find essential differences in the obligation to absorb losses. * Risk absorbers: At a certain level, some speculators will absorb financial risks and seek profits (similar to the primary division of CDO). This is often the participation of individual entities with collateral, or it's really a separate similar equity position in the network, or the role of participants acting as miners (or verifiers) in the network. * Stablecoin holders: the main human body that constitutes the demand side of the stablecoin market (similar to the holders of the higher level credit tranches of CDO) * Issuance: The niche or algorithm that determines the issuance of stablecoins. It can be determined by multiple individuals in the device, or it may sort out algorithms. * Governance: The main human body or algorithm that manages the protocol parameters, similar to the stock position when managing CDO. * Data provider: Import the information of external assets in to some functions of the blockchain. * Miners: determine the individuals who verify and package transaction operations in the fundamental blockchain layer. The style of different noncustodial stablecoins shows how several components are interconnected. This sort of noncustodial stablecoin brings new risks, so existing financial models cannot be used "out of the box". Here we discuss three forms of new risks. The danger of deleveraging first is the danger of a unpredictable manner of deleveraging, that's, the debt level of maintaining stable currencies decreases too fast, that leads to the break of the anchor. This risk is substantial. Like in the 36 hours from March 12 to 13, 2020 ("Black Thursday"), industry turmoil associated with the coronavirus caused the crypto market to get rid of 50% of its market value. On the ETH network, this leads to network congestion and high gas handling fees, which often decelerates the transaction speed and leads to transaction failures. This caused serious problems for Maker's Dai. Vaults are trying to deleverage since they can't increase collateral or repay their Dai debts. The Keeper either can't quickly obtain Dai's liquidity or can't take part in all debt auctions. Some individuals even started bidding for ETH at a cost near 0 DAI, and almost got about 8 million US dollars in ETH for free. When Black Thursday does occur in March, the affect the price of Maker Dai Source: OnChainFx We've summarized several noteworthy noncustodial stablecoin de-leveraging events, as shown in the dining table. For the designers of stablecoin projects, these events are worthy as case studies.
The danger of oracle failure. Secondly, the oracle service that provides data from the surface to the blockchain may also fail. This can be a major accident, or it might be the result of an attack. Exactly the same risk includes a significant impact and contains occurred several times-we have summarized the notable events in the dining table below. Like in June 2019, FX's price feed error caused the KRW (South Korean Won) price on Synthetix to sky-rocket. At 3 am Sydney time, one of the price feed APIs began to fail intermittently, leading to the purchase price to be had that was 1000 times higher than the current exchange rate of the Korean won. Even though there's a defense mechanism to abandon the outliers, some unfortunate and coincidental results, in the particular calculation, the oracle machine still used the greatly increased expense. As a result, several transactions made a profit of just one, 000 times, causing a profit of more than $1 billion in less than an hour or so. A few incidents of invalidation Governance attacks and miner attacks We've already discussed protocol governance attacks above. In addition , miners also can participate, which is often understood as the second governance method, because miners can decide whether transactions are packaged in to blocks and determine the order of transactions. Smart contract risk As the stable currency adopts algorithmic execution method, without the specific agency supervision, errors in its specification or implementation could have a significant impact. From a modeling perspective, smart contract risk resembles counterparty risk (in this case, it identifies the chance of bugs in execution). The figure below shows what are the results when this type of bug is maliciously exploited. As a result of re-entrancy bug, the locked assets in the lending agreement dForce were stolen and changed from $25 million to $19, 000 within a few hours.
Establishing a risk-based economic foundation We've proposed some models that can be used as the basis for risk analysis of those risks. A assortment of models we propose draws on the main city structure model. Taking inspiration from the models developed in the context of initial public offerings (IPOs), we adjusted these models to capture incentives for governance token holders, stablecoin holders, and risk absorbers. The second kind of model is the bifurcation model. The main city structure model only considers an individual time step: Based on the expectations of agents, they are going to choose to perform certain actions within the next round. The bifurcation model is an extension of multi-round proxy decision-making. The third kind of model is the price dynamic model, which simulates the interaction of different individuals in a structure similar to the CDO, combined with feedback effect in the stablecoin system.
