Chapter 13 of the book Reckless: The Story Of Cryptocurrency Interest Rates is published below. The full book is available on Amazon. The book was written before the bankruptcy of FTX and therefore does not include coverage of this event. However, the book does provide useful commentary in the run up to the failure of FTX, which provides context for the eventual calamity.
While the centralised cryptocurrency exchanges remained dominant in terms of volume and price formation, in 2020 decentralised exchanges started to gain traction. A centralised exchange means that the exchange is run by a single company on a server, alternatively, a decentralised exchange is when exchange processes, such as the execution of orders, matching and settlement occur on a distributed system, such as a blockchain. Critically, there is no custodial relationship between users and a decentralised exchange. A true distributed exchange (DEX), with an aggregated order book, should be considered as one of the other holy grails of financial technology. A truly unstoppable exchange could be transformational to the financial world.
The KYC Problem
A key problem for the centralised exchanges is regulatory pressure. Financial services are typically a highly regulated industry. Exchanges and derivatives markets in particular, are especially tightly regulated. The authorities and regulators may want to protect consumers from themselves, by limiting the types of products they can trade or invest in or restricting them from using certain platforms, especially unregulated platforms that could be hacked or lose client funds. For example, regulators could ban leverage over a certain threshold for retail customers, unless they jump through certain hoops. Another notable example is that the authorities may not want financial markets to cover certain areas like politics. In 2012 political betting platform Intrade was shut down by the US authorities (the CFTC). The authorities may also want to prevent or deter money laundering, forcing centralised exchanges to adopt know your customer (KYC) processes. Many users did not want to participate in the KYC process for a variety of reasons:
- The cumbersome KYC degraded the user experience of the platform.
- Users may refuse to participate in KYC for ideological privacy related reasons, perhaps as libertarian users, they do not believe the authorities should be able to see what financial activities they participate in.
- Users may be concerned about the platform storing their personal details and being hacked, a common occurrence in the space, which could jeopardise user privacy.
- Users may be trying to avoid capital gains tax on their cryptocurrency gains and do not want their respective governments to find out about their gains.
- Users could reside in a location where trading in the financial products they want to trade is banned.
- Users could actually be genuine money launderers, using cryptocurrency trading to hide the proceeds of crime.
While there are a variety of issues related to the KYC process, the truth is that the most significant was the degraded user experience of the cumbersome process, which often involved a photograph of the customer holding up an ID document, which was supposed to be visible to the camera. Retail traders want a fast and easy experience and easy access to leverage. KYC was therefore a major consideration in the marketplace. Platforms that avoided it or set higher thresholds before KYC applied, could gain market share.
This is where DeFi had an opportunity. If trading could be offered in a decentralised way using a blockchain, there would be no central entity the regulators could approach. This would be a dream for the libertarians and financial freedom advocates. Therefore, these decentralised platforms could offer a superior user experience and win in the market. Besides, a considerable part of the reasoning for regulations would no longer be applicable anyway, since a decentralised exchange was non-custodial, there was no risk of the exchange being hacked or otherwise running off with the money. On the other hand, it is possible a bug in the exchange’s smart contract could result in an equivalent loss for customers.
Decentralised Exchanges
A DEX is certainly technically possible, within the confines of a single blockchain ecosystem and the tokens which exist within that system. Since all the tokens are native to the blockchain, one can build an exchange, with a centralised order book and clearing mechanism on top of the blockchain. This can be done on Ethereum for example. The main challenges are scalability, liquidity, usability and ensuring the fairness of the exchange.
Counterparty
Back in 2013, what is widely regarded as the first Initial Coin Offering (ICO) in the space occurred, Mastercoin. The aim of the project was to be a protocol to launch multiple tokens on top of Bitcoin. Essentially surplus Bitcoin transaction data was interpreted by the Mastercoin protocol, as issuing or spending additional tokens. A Mastercoin foundation was set up to manage the proceeds from the ICO. However, there was considerable pushback from the community about the foundation and the unfairness behind the idea that a select few would be given the privilege of managing and controlling the ICO funds.
Therefore, towards the start of 2014, a rival project was set up, Counterparty. This had the same premise as Mastercoin and also had a token, XCP, compared to Mastercoin’s MSC. However, rather than having an ICO, where a select group would manage the funds, there was a “proof of burn”, where Bitcoin were sent to a provably unspendable address and the initial XCP coin allocation was decided by who destroyed the most Bitcoin. This avoided the need for a controversial foundation. Due perhaps to this “fairer” token launch, and the hard work of lead developer Adam Krellenstein, the Counterparty protocol succeeded in becoming the dominant token issuance platform in the space. The XCP token itself was necessary to pay a fee to create new tokens, however other than that there was limited use for it.
The most interesting and exciting feature of Counterparty was undoubtedly the DEX. All Counterparty tokens could be traded on the DEX, which operated on top of the Bitcoin network. A Bitcoin transaction had extra data which could be interpreted by the Counterparty protocol as either a bid, an offer or an order cancellation. If a Bitcoin block contained a matching bid and offer, the protocol would consider the trade executed.
Counterparty’s DEX failed to gain significant traction, primarily for five reasons:
- User experience – The user experience was not compelling, particularly due to Bitcoin’s target block time interval of ten minutes, which normally means users had to wait several minutes after taking an action, like submitting an order, before it appeared on the order book.
- Lack of liquidity – Liquidity on the DEX was low and there was little incentive to be a market maker. At the same time adjusting orders was a time consuming and difficult process, which resulted in market makers having to conduct cumbersome and high risk on-chain processes, to maintain liquid markets with tight spreads. Market makers were also exposed to the risks of miners front running their orders. Liquidity essentially dried up on the platform for most of the time.
- Scalability – Bitcoin fees were already becoming significant at this point, especially for large Counterparty transactions. Having to pay a large fee, perhaps a dollar, just to submit an order, was too much of a burden for some.
- Perceived Bitcoin culture – Perhaps even more important than scalability was the cultural issue. Some in the Bitcoin community did not welcome this kind of activity on-chain. They considered Bitcoin as more serious than all these “joke tokens”. Many considered that the DEX would increase validation costs, increase transaction fees or result in misaligned incentives. It is this cultural perception that drove much of the token issuance and DEX type activity away from Bitcoin.
- Timing – The ecosystem was simply too small and niche at the time to be ready for DEXs. Many members of the community were still familiarising themselves with more basic concepts such as transaction confirmations.
Mastercoin eventually rebranded as Omni and the old Mastercoin token was no longer used. USDT was then issued on the Omni layer and this eventually became a large success, as Counterparty faded into irrelevance. Later on, USDT migrated to other chains and even Omni was barely used.
IDEX
The Counterparty model was emulated, to some extent, on Ethereum by the first generation of Ethereum DEXs in around 2018. Since most of the alternative tokens, by value, exist on Ethereum rather than Bitcoin, developers have little choice but to select Ethereum as their DEX platform. As there was now a rich and wide variety of tokens that existed on Ethereum due to the 2017 ICO boom. These DEXs were therefore more attractive to speculators. The most notable and popular of these Ethereum DEXs in 2018 was IDEX.
Like Counterparty four years earlier, on IDEX, bids, offers and order cancellations were submitted to the Ethereum blockchain, resulting in one aggregated order book. Traders deposited funds into an Ethereum smart contract and the signature of both the traders and the IDEX platform was required to submit orders, execute trades, or make payments.
However, to solve many of the user experience issues, orders were centrally submitted to an IDEX server first, after which IDEX then added their signature to the transaction before broadcasting it to the Ethereum network. Order submission, order cancellation, and order matching was conducted off-chain on the IDEX servers, to allow for a fast and seamless user experience. The events were then submitted in sequence to the Ethereum blockchain and are only valid with a valid signature from the users. After a certain time horizon, users could withdraw funds from the smart contract without a signature from IDEX, which protects user deposits in the event that IDEX disappears. Therefore, IDEX was unable to steal user funds or conduct trades without user authorisation. On the other hand, users had to trust a central entity to determine the sequence of events, but the exchange is still non-custodial. This was essentially a non-custodial exchange rather than a true DEX. However, this was still an interesting achievement and business model.
In early 2019, IDEX was the global number one Ethereum-based DEX, with an approximate market share of 50%. Trading volume was around US$1 million per day at the peak. IDEX failed to generate significant market traction, the primary problem was the difficulty in generating liquidity, due in part to the large amount of on-chain data which would be generated by would be market makers. The model did not work for a blockchain with the capacity of Ethereum.
Uniswap & Curve
The next group of DEX protocols to cover is Uniswap, and another similar project, Curve. Uniswap launched towards the end of 2018, the protocol enjoyed slow and steady growth until 2020, when growth skyrocketed. After years of trial and error, this is finally a model that is a success story, with significant trading volume. Rather than having the traditional order book structure, Uniswap and Curve use liquidity pools for each trading pair. The concept of these reserve liquidity pools is said to originate from the Bancor protocol, first described in a 2017 paper. Those who participate in these pools provide liquidity for traders, with different liquidity pools for each trading pair. These liquidity providers are often called automated market markets (AMM), in contrast to the traditional non automated “manual” market makers on centralised platforms. And yes, you guessed it, by participating in these pools one can earn a yield.
This is a bit of an oversimplification, but the price ratio between two tokens can basically be calculated by dividing the numbers of each token locked in the liquidity pool. For example, take the USDC vs Ethereum trading pair. If the pool contains 4,000 USDC and 10 Ethereum, the Ethereum price can be calculated as 4,000/10 = US$400. This means that each side of the pool has around the same value in it. In simple terms, this US$400 price is the value at which the smart contract allows one to trade Ethereum for USDC or USDC for Ethereum, at least in small amounts. USDC vs Ethereum tended to be the most popular trading pair in DeFi.
This ingenious but reasonably simple mechanism incentivises liquidity providers to ensure the value of the two tokens in the liquidity pool is at the appropriate level. If the market price of one of the tokens changes and market makers do not adjust the liquidity pool sizes, traders could exploit this by purchasing tokens at a lower than market price. Going back to our earlier example, if the price of Ethereum suddenly crashes to US$200, traders would be incentivised to use the smart contract to sell Ethereum to the pool, thereby adding Ethereum to the pool and removing USDC. The losses liquidity providers suffer as a result of these price movements is known as impermanent loss.
The above methodology works to some extent, however it still needs to address the issue of liquidity, slippage and large orders. The core operating principle behind Uniswap, created to address this liquidity issue, is related to the curve y = 1/x. The x and y-axis represent the number of tokens of each coin in the liquidity pool and each point on the curve represents a possible state of the pools. The liquidity pools will only accept and execute a trade if the area under the new equilibrium point is higher than the area before the swap. This means that if a trader submits a larger order, they will execute at an inferior price to a trader with a smaller order. In general, the higher the volume one wishes to trade, the more slippage the trader will experience.
The Curve protocol can have a unique equation for each trading pair, which can be set according to the market structure of the coins in question, depending on for example the expected price volatility between the two coins. Hence the name Curve.
With this AMM system there is no orderbook, but merely two pools of funds and this alone is sufficient for trading. This makes market making far easier than constantly using the blockchain to adjust orders, as blockchains may not have the capacity for this. In normal market conditions, market makers can just provide liquidity into the pool instead of regularly adjusting their orders as the price changes, significantly reducing the usage of the cumbersome and expensive blockchain. This clever mechanism essentially partly solved the liquidity and scalability problems with respect to Counterparty and IDEX.
When providing this liquidity on Uniswap or Curve, you can earn a yield. For example, when a trade is executed on Uniswap, a fee of 0.3% is charged. These fees are then sent to the liquidity providers, in proportion to the amount of liquidity which has been provided.
Trading activity on these DEXs rapidly picked up in the summer of 2020, the so-called summer of DeFi. According to CoinGecko, in February 2020 less than US$1 billion of volume occurred on these protocols. By August 2020 monthly trading volume had reached US$12.7 billion. In 2021 the market picked up further. In May 2021 monthly trading volume peaked at over US$200 billion. Uniswap accounted for almost 60% of the volume of these DEX’s in most months. In contrast, Curve was doing around 10% of DEX market volume. In 2021, total DeFi trading volume represented around 8% to 9% of the spot volume on centralised cryptocurrency exchanges. This is a remarkable success, especially since much of the centralised cryptocurrency exchange volume has very low fees and therefore volume can be cheaply manipulated. In the first half of 2022, DeFi trading volumes were around the same as 2021, however the market share compared to centralised exchanges grew substantially, as centralised exchange volume declined in 2022 after the 2021 bull market. DeFi trading volume had proved more robust than the centralised competition, quite a success story.
With trading volume on the DeFi protocols skyrocketing in 2021, liquidity providers were earning excellent returns. By placing your USDC in a Uniswap liquidity pool in 2020 and 2021, one could often earn between 15% and 40%. Institutional money was of course slow to deploy to this new area and therefore many specialist cryptocurrency trading firms who were quick to adapt to this performed extremely well. Alameda Research, owned by Sam Bankman-Fried (SBF), who also founded the cryptocurrency trading platform FTX, is perhaps the best example of this.
Food Tokens
It is worth remembering what is driving everything in the space, a desire to speculate on tokens. The narratives were first created by the Bitcoiners. Dreamy narratives about advanced disruptive technology, banking the unbanked, disintermediation, fixing a broken economic system dependent on ever expanding debt and of tokens going to the moon. These narratives were then copied, manipulated, refined and adapted for a growing range of coins, coins which were getting more and more outrageous as time progressed.
Merely trading speculative coins on a DEX and earning decent yields for providing liquidity to facilitate these trades was not enough for some people. Instead, the DeFi contracts enabling this trade and yield could also have their own native tokens. These tokens could be awarded to liquidity providers, a reward for providing liquidity. These newly issued token rewards could then supplement the yield. Liquidity providers could then have two sources of income, trading fees and newly issued token rewards. Traders could also be awarded these newly issued tokens as a reward for trading on the DEX platforms. These new tokens could also appreciate in value, a virtuous cycle creating more and more wealth and more and more yield. With this token issuance model, yields could be a lot higher than 15% to 40%. One could earn 40% or 80%. When a protocol was new, the advertised yields could be even higher, in the thousands or even millions of percent per annum. Of course, these rates were extremely volatile and not sustainable for any reasonable amount of time.
For some reason, many of these DEX contracts were named after food. For example, SushiSwap and PancakeSwap being two of the most famous. There was also Burger Swap, Yam Finance, Bakery Swap, Pizza, Hotdog Swap and Kimchi Finance, just to give a few examples. The more obscure, new and mad the platform was, the higher the yield one could earn from it. In some cases it was less and less clear what the smart contract and token actually did. One could just deposit funds into a smart contract and earn a ludicrously high yield, based on the new tokens being issued. The annual yield was sometimes quoted in so many digits, it wasn’t easy to determine how large it was. Was the annual yield in the billions or trillions of percent? If it even mattered. It was almost as if the more stupid a token was, the more yield needed to be offered to attract investors.
In an infamous interview with Bloomberg in April 2022, Sam Bankman-Fried (SBF) controversially, but somewhat accurately described the situation as follows:
Let me give you sort of like a really toy model of it, which I actually think has a surprising amount of legitimacy for what farming could mean. You know, where do you start? You start with a company that builds a box and in practice this box, they probably dress it up to look like a life-changing, you know, world-altering protocol that’s gonna replace all the big banks in 38 days or whatever. Maybe for now actually ignore what it does or pretend it does literally nothing. It’s just a box. So what this protocol is, it’s called ‘Protocol X,’ it’s a box, and you take a token. You can take Ethereum, you can put it in the box and you take it out of the box. Alright so, you put it into the box and you get like, you know, an IOU for having put it in the box and then you can redeem that IOU back out for the token.
So far what we’ve described is the world’s dumbest ETF or ADR or something like that. It doesn’t do anything but let you put things in it if you so choose. And then this protocol issues a token, we’ll call it whatever, ‘X token.’ And X token promises that anything cool that happens because of this box is going to ultimately be usable by, you know, governance vote of holders of the X tokens. They can vote on what to do with any proceeds or other cool things that happen from this box. And of course, so far, we haven’t exactly given a compelling reason for why there ever would be any proceeds from this box, but I don’t know, you know, maybe there will be, so that’s sort of where you start.
And then you say, alright, well, you’ve got this box and you’ve got X token and the box protocol declares, or maybe votes by on-chain governance, or, you know, something like that, that what they’re gonna do is they are going to take half of all the X tokens that were re-minted. Maybe two thirds will, two thirds will offer X tokens, and they’re going to give them away for free to whoever uses the box. So anyone who goes, takes some money, puts in the box, each day they’re gonna airdrop, you know, 1% of the X token pro rata amongst everyone who’s put money in the box. That’s for now, what X token does, it gets given away to the box people. And now what happens? Well, X token has some market cap, right? It’s probably not zero. Let say it’s, you know, a $20 million market
You might think, for instance, that in like five minutes with an internet connection, you could create such a box and such a token, and that it should reflect like, you know, it should be worth like $180 or something market cap for like that, you know, that effort that you put into it. In the world that we’re in, if you do this, everyone’s gonna be like, ‘Ooh, box token. Maybe it’s cool. If you buy in box token,’ you know, that’s gonna appear on Twitter and it’ll have a $20 million market cap. And of course, one thing that you could do is you could like make the float very low and whatever, you know, maybe there haven’t been $20 million dollars that have flowed into it yet. Maybe that’s sort of like, is it, you know, mark to market fully diluted valuation or something, but I acknowledge that it’s not totally clear that this thing should have market cap, but empirically I claim it would have market cap.
Leverage
Systems like Uniswap and Curve can almost be considered as a base layer of DeFi. It was akin to the centralised spot exchanges. All you could do with them is swap tokens and provide liquidity. What traders really wanted was leverage. DeFi also provided this. Ethereum smart contracts such as Compound & AAVE allowed users to deposit a coin as collateral, to borrow another coin. What made these systems so popular was the ability to combine borrowing with DEXs, to increase leverage and speculate on price changes. Just like the borrowing on Bitfinex around seven years earlier, people were not borrowing to invest in the real economy, they were borrowing to speculate on cryptocurrency tokens with leverage.
For example, one could provide Ethereum as collateral on Compound and borrow Dai. Then, in a second step, use Uniswap to swap this Dai back into Ethereum. Then, step three would be to use the Ethereum as collateral Compound again, borrowing more Dai. This cycle of rehypothecation can occur multiple times. Thereby, using multiple DeFi protocols to obtain leverage to increase exposure to Ethereum. This is just what some of the Ledn clients were doing in the centralised world. Now they could do this on DeFi too, with zero KYC. In order to borrow, typically there is a collateral requirement of around 75%, which means if you have US$100 worth of Ethereum in your account, you could borrow up to US$75 worth of Dai or USDC. If an account falls below the necessary collateral requirement, the smart contract liquidates the position. The way this works is that other users can repay a portion of the debt and in return receive a portion of the collateral. The account who took over the liquidated position purchases the collateral at a discount, for example an 8% discount, which encourages them to take over the position. The smart contract calculates the solvency of each account by using third party price oracles, who submit price data into the Ethereum blockchain.
Both Compound and AAVE were relatively similar in terms of scale. In the summer of 2020, both platforms had a few million dollars in outstanding debt. From this point onwards debt levels expanded rapidly, each growing to around US$8 billion of debt by around May 2021. The most common coins that were borrowed were Dai and USDC, which dominated the outstanding debt.
The rate at which you could borrow the US Dollar stablecoins on Compound was quite volatile. The variable interest rate typically ranged from between 5% to 20% from the summer of 2020 until the end of 2021. During periods of peak cryptocurrency speculation, for example, in April 2021, rates were at elevated levels, typically at around 13%, based on seven day moving averages. These attractive rates were much higher than the official base rate in the economy, which was near zero at the time. When investors were starved of yield, deploying capital into DeFi and engaging in reasonably low risk lending, due to strong collateral requirements, was quite attractive.
Somewhat ironically, as the cryptocurrency bull market ended, towards the end of 2022 the DeFi borrow rate declined to around 2%, lower than the base rate set by the Federal Reserve. Lending US Dollars in DeFi in the second half of 2022 was far less attractive. In contrast the rate at which one could borrow Ethereum on Compound has always been stable and low. Ranging from about 2% to 3%. One could also borrow Bitcoin on Compound, custodial Bitcoin in the form of WBTC, a service provided by a company called Bitgo. Here rates were typically lower than US Dollar stablecoin rates, but far more volatile than Ethereum rates. The Bitcoin borrow rate was typically around 4%, with the occasional spike up towards 10% or even 20% at times. The cost to borrow all the other cryptocurrencies was almost always higher than Ethereum, although volume here was much lower.
Compound – USDC Lending Rates (Weekly Averages)
Source: The Block
May 2021 Crash
May 2021 saw a cryptocurrency price crash. From 15 May 2021 to 19 May 2021 the Ethereum price crashed by 53%, from over US$4,000 to under US$2,000. The Bitcoin price also declined from about US$56,000 to US$38,000 in the period. In the grand scheme of things this was not a big deal. Indeed, the Ethereum price had been at the US$2,000 level just a month earlier. Of course, cryptocurrency had crashed significantly before, for example March 2020, which was covered earlier in this book. The reason this crash was potentially significant, was because it was the first major correction since DeFi had taken off.
Some of the critics of DeFi had made the following argument:
- DeFi systems are used to speculate on tokens and there are very few other legitimate use cases of DeFi.
- There is considerable debt and leverage in the DeFi system, at unsustainably high levels. This leverage is the epicentre and critically the fundamental cause of the extreme cryptocurrency price appreciation experienced in 2021. Ethereum is considered a high-powered machine of speculation and leverage.
- Much of the capital has entered DeFi due to dangerously high yields on offer, which are not sustainable.
- The DeFi boom has occurred in a bull market and in that environment it works fine. However, when times change and a crash happens, we will see cascading liquidations across DeFi.
- The smart contracts may struggle to handle the extent of liquidations, perhaps due to bugs and the Ethereum network will become congested.
- The large amount of deleveraging may prove that most DeFi protocols are economically weak and susceptible to attacks.
- The value of funds locked inside the protocols will decline rapidly and many users will lose funds and the system will struggle to recover.
- The price of many cryptocurrencies will then crash and we will enter a prolonged bear market cycle.
There are of course many truths to these criticisms, which were articulated by some sophisticated macro investors in the period. However, by and large, the DeFi protocols handled the crash reasonably well and the critics were shown to be mostly wrong. In May 2021 there were US$400 million and US$300 million of liquidations on AAVE and Compound respectively. The most common form of collateral which was liquidated was Ethereum, followed by WBTC, which were both used to borrow US Dollar stablecoins. AAVE witnessed small drawdowns in the outstanding loan balance, before quickly continuing with its upwards trajectory. The centralised cryptocurrency exchanges processed around US$10 billion of long liquidations during the May 2021 crash.
As for Ethereum network congestion, the lending protocols handled this reasonably well, at least much better than some protocols handled the March 2020 crash. Ethereum fees did spike much more in 2021 than in 2020, the top paying transactions paid around ten times more in the May 2021 crash than the March 2020 crash. However, the key liquidation orders did get through into the blockchain in a timely manner. Around US$35 million of positions were liquidated because the loan repayment transactions were not processed by the network in time, as the transaction fees were too low. This is not great for the traders involved, but this is a far lower value than it could have been.
Critics of DeFi could still argue that the crash was not large enough to cause the pain and chaos some had anticipated. It could also be argued that some of the most successful and highly profitable trading shops with large balance sheets had provided liquidity, in a coordinated way, at critical times during the May 2021 crash to prevent widespread cascading DeFi liquidations.
While it may have been true that 2021 can be characterised as an outrageous, unsustainable, leveraged and greed driven cryptocurrency bubble, it’s probably not true to say that DeFi caused the bubble, nor is it true to say DeFi was at the bubble’s epicentre. The lesson from the May 2021 crash was that the mechanics and structure of the market was somewhat different than the DeFi critics had expected. The leading DeFi protocols were more resilient than the critics thought. It was centralised actors which were to blame for the most severe extremities of the 2021 bubble. However, of course within DeFi there were examples of sheer madness, such as the food tokens. But the most egregious and stupid lending decisions appeared to have been made using traditional centralised systems, rather than on DeFi.
The Anchor Protocol
One of the key drivers in the growth of Luna and the UST stablecoin was a lending system called the Anchor protocol. This newer system may not have had the resilience of protocols like AAVE and Compound. Anchor was a lending protocol on the Luna blockchain, where users could make deposits into the system and earn a yield. Anchor deposits climbed from around US$50 million in March 2021 to an astonishing peak of around US$15 billion at the end of April 2022. This deposit balance experienced solid straight line type growth throughout the period, just like the UST outstanding balance growth.
Typically, around 40% to 60% of UST in issuance was deployed in the Anchor protocol. A fraction of these deposits was lent out. At the peak, the loan book was around US$3.5 billion, a loan to value ratio of around 30% compared to the deposit base. The Anchor protocol also had a governance token called ANC.
The Anchor protocol was all about yield, paying depositors an attractive and stable yield of 20%. This 20% rate was key to the marketing behind Anchor and indeed UST. The objective of the protocol was to stabilise interest rates, compared to the more volatile rates on the other DeFi lending protocols in Ethereum.
The protocols on Ethereum, such as AAVE and Compound, connect lenders and borrowers together. Anchor works slightly differently, instead of more directly connecting borrowers and lenders, there is a pool of reserves in the protocol in the middle, called the yield reserve. Borrowers borrow from the reserve fund, making interest payments to the reserve fund. On the other hand, depositors send funds into the reserve and receive interest payments from the reserve fund. The interest rates are claimed to be algorithmically determined, by a formula that uses the size of the various pools of funds. The core advantage of this structure, compared to AAVE and Compound, was that interest rates were more stable as the reserve fund could weather the impact of short-term imbalances in supply and demand. The system was described in the Anchor whitepaper as follows.
The core building block of the Anchor savings protocol is the Terra money market – a WASM (Web Assembly) smart contract on the Terra blockchain that facilitates depositing and borrowing of Terra stablecoins (TerraUSD, for instance). The money market is defined by a pool of Terra deposits that earns interest from borrowers. Borrowers put down digital assets as collateral to borrow Terra from the pool. The interest rate is determined algorithmically as a function of borrowing demand and supply, which is encoded by the pool’s [utilisation] ratio (fraction of Terra in the pool that has been borrowed).
This book does not attempt to cover the formula for determining these interest rates in detail and it does not appear that this formula was actually used. Instead, the interest rates seemed to be controlled by TFL.
Throughout the existence of Anchor, because only around 30% of the funds deposited were loaned out, due to a lack of demand to borrow, the protocol had negative cash flows. This means that interest payments were higher than interest receipts. The yield reserve fund was therefore continually drained.
In October 2021 the yield reserve was around US$70 million, due to the initial capital it was provided with by TFL. By February 2022 this had been depleted to just US$6 million. At this point Do Kwon announced via Twitter that the LFG would inject 450 million UST into the yield reserve fund. Without this injection of capital, the fund could not afford the interest payments. The 20% yield could therefore be maintained and the yield reserve fund continued to be depleted into the first half of 2022. As yields in DeFi continued to decline into 2022, the promised 20% yield became less and less sustainable. Therefore, rather than the algorithmically determined interest rates which the whitepaper proposed, it appeared as if the TFL was determining the interest rates manually, by artificially injecting capital into the reserve fund to maintain the 20% rate.
The decision to keep the deposit rate at 20% was controversial at the time and many saw the yield as unsustainable. In early 2022 venture firm Polychain Capital argued yield paid outs on balances exceeding 100,000 UST should be reduced. A formal governance proposal was created, which would see deposits under 100,000 UST receive 19.56%, while deposits between 100,000 UST and 500,000 UST would be paid 17.5% and deposits valued greater than 500,000 UST would get 10%. The proposal suggested reducing the rates for medium and large deposits linearly over 19 months at 30-day increments. Caps like this would keep the small retail depositors happy, while lowering rates for larger investors and adopt a similar cap system structure to centralised lending platforms like BlockFi. However, the proposal lost the vote, with over three-quarters of the votes rejecting it. The aim of the proposal was to make the Anchor protocol more sustainable and keep interest rates more realistic, given the prevailing market conditions of declining returns across the DeFi space.
Continuing to subsidise the yield, with money from the LFG could not last forever. Remember, the LFG funds were raised from outside investors (directly or indirectly via Luna sales) and eventually the investor funds would run out and the system would be dependent on more and more investors to keep it running. It is also not clear if investing in a company to subsidise returns for other investors, is an intelligent investment strategy. On the other hand, in this case, many of the initial investors in Luna, TFL and the LFG, may have been the same entities which were participating in Anchor.
The proposal was probably rejected for several reasons. It is possible many of the voters were receiving these 20% interest payments and wanted these good times to continue. In particular, many of the entity’s earning interest may have borrowed money at perhaps around 10% and were making a killing on the 10% spread. They wanted these good times to continue.
The announcement of the 450 million UST capital injection sent the price of Luna skyrocketing, up from US$50 to US$90 in a few days. This represented significant outperformance compared to other cryptocurrencies such as Ethereum. It is likely that Do Kwon and other Luna investors wanted to keep the party going.
Just like BlockFi, the philosophy of Luna and Anchor was about winning users and growth. It was fine if the Anchor reserve was depleted over the short to medium term, because it was about winning market share and attracting users. Over the long term, once Anchor was the winner, it could lower the deposit rate and start to sustainably generate cash flow. The 450 million UST spend was considered as a marketing cost for TFL. At the time, many considered Anchor as the largest DeFi protocol in the world, with the amount deposited exceeding any other DeFi project on Ethereum. Anchor was working and it was winning, while cryptocurrency, blockchain, DeFi and web3 was a major global paradigm shift. TFL/LFG had significant reserves, due to the skyrocketing Luna price and it was certainly worth spending the cash in the short term to secure Anchor’s position as the winner. At least this is what they are likely to have thought at the time.
Back Down To Earth
Anchor aside, which perhaps wasn’t really a DeFi project after all, DeFi involves highly complex and advanced technological innovations. These technologies can enable people to engage in new types of financial activity, which could transform the world of finance. On the other hand, it’s still appropriate to be sceptical about DeFi. DeFi needs to be evaluated in the right context. DeFi is used by traders wishing to speculate on cryptocurrency prices, often with leverage. DeFi is very much a continuation or replacement of what happened on Bitfinex in 2016 and then BitMEX in 2018. As a platform for this kind of trading, DeFi is successful and some of the larger, more established and stronger DeFi platforms, like Uniswap and AAVE are reasonably robust. However, hopes of DeFi based systems revolutionising finance in the real economy, for example helping provide finance for real world investment projects in a meaningful way, are somewhat farfetched, at least at this point.
In 2021 one could earn attractive yields on DeFi and doing so appeared exciting, it seemed the way of the future. Many people wanted to deploy capital into DeFi, however it was more challenging than many people expected. Managing liquidity pools and being in the loop about the next new high yield token was too challenging for many potential investors. This is where the earn business model comes in. One could deposit cryptocurrency with the earn platforms and they could deploy this money into DeFi for you. Alternatively, the earn platform could lend your funds out to specialist proprietary trading firms, who could deploy the money into DeFi. The investors would therefore never need to worry about impermanent loss, managing private keys, dealing with skyrocketing Ethereum gas fees or dealing with various front running type DeFi attacks, but they could still earn the amazing returns DeFi offered. DeFi could be accessed via intermediaries and some of the earn platforms had a nice and friendly narrative explaining the attractive yields they provided, it was DeFi.