Decentralised Yield and Embedded Risks
Unpacking yield and sources of risk in crypto. Conducting a post-mortem on the LUNA-UST meltdown.
Key takeaways
- Technical complexity and tokenomic design can often obfuscate risks borne by crypto investors.
- A corollary in finance is that the yield (or return) from an asset must be commensurate with the risk to its holder.
- Different assets are subject to different types of risks: all traded crypto assets are subject to market and liquidity risk; staked assets are subject to the risk of slashing; dApps are subject to smart contract risk; stablecoins and other synthetic assets are subject to depeg risk; and so on.
- The risks borne by users are virtually endless and highly specific to each protocol and its construction. Users should make their best attempt to understand the mechanics, intricacies and embedded risks of each ecosystem, before apeing in.
- The recent meltdown of LUNA, UST and the Terra ecosystem serves as a good case study for evaluating the risks associated with blockchain protocols. While the core product on the ecosystem, Anchor, offered attractive depository yields of 19.5%, it embedded a package of market, smart contract-related and depegging risks which offset the attractive returns.
- Risks are often difficult to perceive before they fully materialise. Whenever we are drawn by the prospect of high returns, we should be careful to consider fully the counterweighing risks.
Technical complexity and tokenomic design can often obfuscate risks borne by crypto investors. With the market-wide slump and recent meltdown of UST, it is a good moment to pause and reflect on the risks embedded in crypto assets.
No pain no gain
A corollary in finance is that in an efficient market, the yield (or return) from an asset must be commensurate with the risk borne by its holder. Given two assets with the same return, investors will always choose the one with lower risk, so to attract investors to the riskier product, issuers must offer a higher return.
Not all risk is made equal. Different assets will be exposed to different types of risks. For example:
- Unsecured lending is subject to default risk, meaning the risk that the borrower is unable to repay their debt obligations
- Vested shares are subject to liquidity risk, meaning the risk associated with the inability to transact the investment for cash
- Tokens are subject to smart contract risk, meaning they are vulnerable to hacks and other exploits that could result in the loss of funds.
Sources of risk in crypto
Layer 1 blockchains form the foundational layer of all decentralised applications. Holding tokens issued by Layer 1s and interacting with their smart contracts exposes users to a plethora of risks. Below is a non-exhaustive list to consider before deploying funds into a new protocol.
a) Tokens / Market risk
Tokens issued by Layer 1 blockchains and dApps and traded on public markets are subject to market risk. In particular, the price of these assets fluctuate constantly, exposing holders to market volatility. The realisable value of investments may, as a consequence, be lower than their instantaneous market value.
Traded assets are also subject to liquidity risk. An asset can only be sold if there is a willing buyer to take the other side of the trade (or in the case of an AMM, a pool of liquidity to transact against). When liquidity dries up, spreads increase and assets can become more expensive to buy or sell, further reducing their realisable value.
b) Staking / Risk of slashing
Most native protocol tokens can be staked to earn what is known as a staking yield. In the case of blockchains, this compensates asset owners for validating the network, whereas in the case of protocols, it compensates holders for participating in protocol governance.
Staking yields are considered to be a relatively ‘risk-free’ type of yield, but even so, validation is not without its risks. In particular, validators are subject to a range of operational and technical risks that can lead to the slashing (i.e. confiscation) of deposited funds — a mechanism designed to punish bad actors in the system, but that may be triggered by non-malicious factors such as server downtime.
c) Self custody / Risk of human error and hacks
Participating in a decentralised network means holding your own funds in a self-custodial wallet. However, wallets can be prone to a loss of funds due to hacks, or even just simple human error. Crypto is a dark forest, and there are infinitely many attack vectors that malicious actors can exploit — from phishing attacks to stray email links. Generally speaking, using a hardware wallet and keeping hot and cold wallets seperate are good practices for safely preserving value.
d) Centralised providers / Counterparty risk
A consequence of the risks of self custody is that many users choose to outsource custody to a third party provider. Unfortunately, holding coins in a centralised exchange means trading off self custody risk for counterparty risk. As the saying goes: “not your keys, not your coins”. Frankly, leaving your money with someone else doesn’t insulate you from technical risks either. Centralisation could make those assets more, not less, prone to attack. It also goes against the ethos of decentralisation and permissionless networks.
e) dApps / Smart contract risk
Blockchain-based applications are powered by smart contracts which express the application’s functionality in the form of composable blocks of code. As a general rule, anything that involves a smart contract will be subject to smart contract risk.
Smart contracts power the vast majority of value created on the blockchain, but their expressiveness is a double-edged sword: just as the functionality and use cases they support are virtually infinite, so too are the attack vectors and potential vulnerabilities, many of which are non-obvious even to experienced developers.
Smart contract risk can be managed through extensive, regular audits and enlisting the help of white-hat hackers. However, they can never be entirely mitigated and must be accepted as a cost of doing business on the blockchain.
f) Stablecoins and other synthetic assets / Depeg risk
Stablecoins are on-chain representations of off-chain currencies. They are a family of synthetic assets — derivative instruments engineered to replicate the financial characteristics of an asset without requiring the buyer to hold the underlying.
Stablecoins and other synthetic assets are subject to depeg risk. This is the risk that the traded value of the instrument fluctuates from the value of the underlying asset, which can lead to a loss of value. Maintaining the peg often involves injecting off-chain data by way of a price oracle, which itself could be subject to the risk of data irregularities and other vulnerabilities, with downstream implications for the robustness of the peg (this is what happened with LUNA, as discussed further below).
g) Liquidity pools / Risk of impermanence loss
Assets contributed to a liquidity pool earn yield from trading fees charged on swaps conducted via the pool. However, liquidity providers are exposed to fluctuations in the price of pooled assets, which can affect the asset mix and therefore the value of the assets they hold. This is a form of market risk known as impermanence loss, which liquidity providers need to be compensated for.
h) Ecosystem incentives / Risk of reversal
Ecosystem incentives, or ‘bribes’, are additional rewards paid to ecosystem participants to bootstrap the network. While they may appear risk-free on the surface, they are almost always temporary, meaning the stream of incentives will be phased out over time as the ecosystem matures.
The ‘price’ users pay for these incentives is the risk of reversal. Just as network effects can act as a flywheel for growth, they can also act as a flywheel for decline. When ecosystem incentives run out, you don’t want to be left holding the bag while everyone else has cashed out.
The risks borne by users are virtually endless and highly specific to each protocol and its construction. The risks listed above are a useful starting point, but they should not be treated as exhaustive. Users should make their best attempt to understand the mechanics, intricacies and embedded risks of each ecosystem, before apeing in with their capital.
Case study: A post-mortem on UST, Anchor and the Terra ecosystem
The recent meltdown of LUNA, UST and the Terra ecosystem serves as a good case study for evaluating the risks associated with blockchain protocols.
The Terra ecosystem was a bundle of decentralised financial applications running on the Terra blockchain, powered by two interrelated tokens:
- $UST: an algorithmic stablecoin pegged to the US Dollar, which powered all of the financial applications running on the network
- $LUNA: a token that serves the dual purpose of decentralisation governance, and maintaining the UST peg. In particular, LUNA can be redeemed for UST (and vice versa) at a guaranteed price of $1, so when the price of UST fluctuates, arbitrage kicks in to bring it back to parity. A portion of all swapped LUNA is burned, introducing inflationary pressure on the price of the token.
The primary use case for $UST was Anchor Protocol, a lending protocol where depositors could earn a 19.5% annualised yield. This is clearly a highly attractive proposition, so let’s unpack the risks involved:
- Smart contract risk: as mentioned above, anything that involves smart contracts is subject to smart contract risk. Smart contracts on Terrra are written in Rust, and vulnerabilities in the smart contracts could have unintended consequences for the redemption mechanism and UST peg. The redemption mechanism also relies on oracle smart contracts that can malfunction in the event of volatile market conditions and data irregularities. While smart contract risks did not materialise, these are very real and present considerations in all blockchain applications.
- Ecosystem risk: the demand for deposits on Anchor was far higher than the supply of deposits (in fact, creditors were paying only around 10% APY on their loans while depositors were earning 19.5%). The differential yield was being paid for with ecosystem incentives. Ecosystem incentives are unsustainable and don’t last forever. Anchor was paying for this yield out of its own reserves, and there was no guarantee that the demand for the platform could be maintained once those incentives dried up.
- Market risk: the yield earned on deposits to Anchor were partly rendered in the form of $ANC governance tokens, which are publicly traded and therefore subject to market risk.
- Depeg risk: both principal and interest payments on deposits to Anchor were denominated in UST, making UST the lifeblood of Anchor. A deviation in the value of UST directly affected the value of deposits and loans in the ecosystem. Further, the value of collateral deposited into the protocol was calculated based on the traded value of UST, whereas loan liquidations were calculated on the oracle price of USD. A material depeg could trigger loan liquidations even where there was sufficient collateral to cover the loan (this was exactly what happened when UST lost its peg).
- Death spiral risk: related to depeg risk, death spiral risk is a risk specific to the Terra ecosystem which relies on investor confidence to maintain its integrity. Once UST lost its peg, it triggered a loss of confidence by investors and a ‘bank run’ ensued, whereby investors redeemed UST for Luna and sold it on the market, further driving down the value of Luna and reducing investors’ confidence. The Luna Foundation Guard spent almost $3 billion in Bitcoin reserves to try and prop up to price of LUNA, but was ultimately unsuccessful. At a price of <$0.001 (falling from around $85 mere days earlier), LUNA along with the Terra blockchain halted at block 7607789.
Closing thoughts
Risks are often difficult to perceive before they fully materialise. Whenever we are drawn by the prospect of high returns and rewards, we should also consider the counterweighing risks, particularly where these sit at the long tail of probable outcomes.
In this time of market turmoil, we should take the time to fully reevaluate and understand the package of risks we have signed up for. Perhaps when the next LUNA event comes around, we may find ourselves better prepared.
This article was originally published on Open Source Finance.
