On-chain finance, danger! Run away!

Author: Odaily Planet Daily Azuma

DeFi is once again at the forefront of attention.

As one of the most vibrant narrative directions in the industry over the past few years, DeFi carries the hopes for the continued evolution and expansion of the cryptocurrency industry. I, who firmly believe in its vision, am accustomed to deploying over 70% of my stablecoin positions into various on-chain yield strategies, and I am willing to bear a certain level of risk for this.

However, with the recent fermentation of multiple security incidents, the interconnected impacts of some historical events and the inherent problems that were originally hidden beneath the surface are gradually being exposed, creating a dangerous atmosphere throughout the DeFi market. Therefore, I, as the author of Odaily, chose to consolidate the majority of my on-chain funds last week.

What exactly happened?

Upper Chapter: Opaque High-Yield Stablecoins

Last week, several noteworthy security incidents occurred in DeFi. If the theft of Balancer was an unexpected isolated case, then the consecutive de-pegging of two so-called yield-bearing stablecoin protocols, Stream Finance (xUSD) and Stable Labs (USDX), exposed some fundamental issues.

The commonality between xUSD and USDX is that both are packaged as synthetic stablecoins similar to Ethena (USDe), primarily utilizing delta-neutral hedging arbitrage strategies to maintain their peg and generate yield. Such yield-bearing stablecoins have flourished in this cycle, as their business models are not particularly complex, and with the prior success of USDe, various stablecoins have emerged, even experimenting with all combinations of the 26 letters of the English alphabet and the word USD.

However, the reserve and strategy conditions of many stablecoins, including xUSD and USDX, are not transparent enough, yet under the stimulation of sufficiently high yields, these stablecoins still attracted a significant influx of funds.

In relatively calm market fluctuations, these stablecoins could still maintain operations, but the cryptocurrency market is always prone to unexpected large fluctuations. Trading Strategy analysis states (see "In-depth Analysis of the Truth Behind xUSD's De-pegging: The Domino Crisis Triggered by the October 11th Crash" (https://www.odaily.news/zh-CN/post/5207356)), that the key reason for xUSD's significant de-pegging was the opaque off-chain trading strategy of Stream Finance encountering "automatic deleveraging" (ADL) by exchanges during the extreme market conditions on October 11th (for a detailed explanation of the ADL mechanism, see "Detailed Explanation of the ADL Mechanism in Perpetual Contracts: Why Does Your Profitable Position Get Automatically Liquidated?" (https://www.odaily.news/zh-CN/post/5206797)), which broke the originally delta-neutral hedging balance. Stream Finance's overly aggressive leverage strategy further amplified the impact of this imbalance, ultimately leading to Stream Finance's effective insolvency and the complete de-pegging of xUSD.

The situation with Stable Labs and its USDX should be similar. Although its official announcement later attributed the de-pegging to "market liquidity conditions and liquidation dynamics," considering that the protocol has consistently failed to disclose reserve details and fund flow specifics as requested by the community, coupled with the suspicious behavior of the founder's address collateralizing USDX and sUSDX on lending platforms to borrow mainstream stablecoins while unwilling to repay even at the highest interest rates exceeding 100%, the situation of this protocol may be even worse.

The conditions of xUSD and USDX expose serious flaws in the emerging stablecoin protocol model. Due to the lack of transparency, these protocols exhibit a significant black box space in their strategies. Many protocols publicly claim to be delta-neutral models, but the actual position structures, leverage multiples, hedging exchanges, and liquidation risk parameters are not disclosed, making it nearly impossible for external users to verify whether they are truly "neutral," effectively becoming a party that bears transferred risks.

A classic scenario for the outbreak of such risks is when users invest mainstream stablecoins like USDT and USDC to mint emerging stablecoins like xUSD and USDX to earn attractive yields. However, once the protocol encounters issues (and it is necessary to distinguish between real problems and staged events), users find themselves in a completely passive position, and their stablecoins may quickly de-peg under panic selling. If the protocol is conscientious, it may offer some compensation from remaining funds (even if compensation is offered, retail investors are often last in line), but if not, it could result in a soft exit and no resolution.

However, it would be unfair to dismiss all delta-neutral yield-bearing stablecoins. From the perspective of industry expansion, actively exploring diverse yield paths through emerging stablecoins has its positive significance. Some protocols, represented by Ethena, provide clear disclosures (Ethena's recent TVL has also significantly shrunk, but the situation is different; Odaily will write another article on this later). The current situation is that you do not know how many undisclosed or inadequately disclosed protocols have encountered similar issues as xUSD and USDX ------ while writing this article, I can only assume innocence, so I can only use the "exploded" protocols as examples, but from the perspective of my own position safety, I would recommend you assume guilt.

Lower Chapter: Lending Protocols and Curators

Some may ask, can't I just avoid these emerging stablecoins? This leads us to the two main characters in the second half of this round of systemic risks in DeFi ------ modular lending protocols and Curators (the community seems to have gradually accustomed to translating it as "Curator," and Odaily will continue to use this translation below).

Regarding the positioning of Curators and their role in this round of risks, we provided a detailed explanation last week in the article "What is the Role of Curators in DeFi? Could They Be the Hidden Dangers of This Cycle?" (https://www.odaily.news/zh-CN/post/5207336). Interested readers can directly refer to that article, and those who have read the original can skip the following paragraphs.

In short, professional institutions like Gauntlet, Steakhouse, MEV Capital, and K3 Capital act as Curators, packaging relatively complex yield strategies into user-friendly liquidity pools on lending protocols like Morpho, Euler, and ListaDAO, allowing ordinary users to deposit mainstream stablecoins like USDT and USDC with one click to earn high yields. The Curators then decide the specific yield strategies for the assets on the backend, such as allocation weights, risk management, rebalancing cycles, withdrawal rules, and so on.

Since this liquidity pool model often provides more attractive yields than classic lending markets (like Aave), it naturally attracts a surge of funds. Defillama shows that the total scale of liquidity pools operated by various Curators has rapidly grown over the past year, briefly exceeding $10 billion at the end of October and the beginning of this month, and as of the time of writing, it still reports $7.3 billion.

The profit path for Curators mainly relies on performance sharing and liquidity pool management fees. This profit logic determines that the larger the scale of the liquidity pool managed by the Curator and the higher the strategy yield, the greater their profits will be. Since most deposit users are not sensitive to brand differences among Curators, the choice of which pool to deposit into often depends solely on the apparent APY figures. This means that the attractiveness of liquidity pools is directly linked to strategy yields, making the yield of the strategy the core factor determining the Curator's profit situation.

Under the yield-driven business logic, coupled with a lack of clear accountability pathways, some Curators have gradually blurred the safety issues that should be prioritized, choosing to take risks ------ "After all, the principal is the user's, and the profit is mine." In recent security incidents, Curators like MEV Capital and Re7 allocated funds to xUSD and USDX, indirectly exposing many users who deposited through lending protocols like Euler and ListaDAO to risks.

However, the blame cannot rest solely on the Curators; some lending protocols are equally culpable. In the current market model, many deposit users are not even fully aware of the role of Curators, simply believing they are depositing funds into a well-known lending protocol for yield. In this model, lending protocols play a more explicit endorsement role, and they also benefit from the surge in TVL due to this model. Therefore, they should bear the responsibility of monitoring the strategies of Curators, but clearly, some protocols have failed to do so.

To summarize, a classic scenario of such risks is when users deposit mainstream stablecoins like USDT and USDC into a lending protocol's liquidity pool, but most are unaware that Curators are using the funds to run yield strategies and are not clear about the specific details of the strategies. The backend Curators, driven by profit margins, then deploy funds into the aforementioned emerging stablecoins; after the emerging stablecoins explode, the liquidity pool strategy fails, and deposit users indirectly suffer losses. Subsequently, the lending protocol itself may encounter bad debts (it seems that timely liquidation would be better; forcibly locking in the de-pegged stablecoin's oracle price to avoid liquidation could exacerbate the problem due to large-scale hedging borrowings), causing more users to be affected… In this pathway, risks are systematically transmitted and diffused.

Why have we reached this point?

Looking back at this cycle, the trading side has long entered a hellish difficulty.

Traditional institutions only favor a very small number of mainstream assets; altcoins are in a continuous decline with no bottom in sight; insider trading and machine programs run rampant in the meme market; coupled with the massacre on October 11th… a large number of retail investors have merely been running alongside or even incurring losses in this cycle.

Against this backdrop, the demand for wealth management, which seems to offer more certainty, has gradually increased. Additionally, with the milestone breakthroughs in stablecoin legislation, a large number of emerging protocols packaged as yield-bearing stablecoins have appeared in bulk (perhaps these protocols should not even be called stablecoins), throwing olive branches to retail investors with annualized yields often exceeding ten or even dozens of points. Among them, there are certainly excellent performers like Ethena, but it is also inevitable that there are mixed results.

In the highly competitive yield-bearing stablecoin market, to make the product's yield more attractive ------ there is no need for long-term sustainability, just maintaining better data until the token launch or exit ------ some protocols may seek higher yields by increasing leverage or deploying off-chain trading strategies (which may be completely non-neutral).

At the same time, decentralized lending protocols and Curators conveniently address some users' psychological barriers to unknown stablecoins ------ "I know you don't feel secure depositing into xxxUSD, but you're depositing USDT or USDC, and the Dashboard will show your positions in real-time; how can you not feel secure about that?"

The operational status of the above model has been relatively good over the past year, at least without large-scale explosions occurring over a long period. Since the overall market has been in a relatively upward phase, there has been sufficient basis for arbitrage between spot and futures markets, allowing most yield-bearing stablecoin protocols to maintain relatively attractive yield performances. Many users have relaxed their vigilance during this process, and double-digit stablecoin or liquidity pool yields seem to have become the new normal for wealth management… but is this really reasonable?

Why do I strongly recommend you to withdraw temporarily?

On October 11th, the cryptocurrency market suffered an epic bloodbath, with hundreds of billions of dollars in funds being liquidated. Wintermute founder and CEO Evgeny Gaevoy stated at the time that he suspected some protocols running long-short hedging strategies had suffered severe losses, but he was unclear about who had lost the most.

In hindsight, the consecutive explosions of so-called delta-neutral protocols like Stream Finance have partially confirmed Evgeny's suspicions, but we still do not know how many hidden dangers remain underwater. Even for those not directly hit by the liquidation on that day, the rapid tightening of market liquidity after the October 11th crash, coupled with the contraction of arbitrage space due to cooling market sentiment, will increase the survival pressure on yield-bearing stablecoins. Various unexpected incidents often occur during such times, and due to the complex interwoven relationships underlying various opaque liquidity pool strategies, the entire market is prone to a "pull one hair and the whole body moves" situation.

Stablewatch data shows that as of the week of October 7th, yield-bearing stablecoins experienced the largest outflow of funds since the collapse of UST during the Luna incident in 2022, totaling $1 billion, and this outflow trend is still ongoing. Additionally, Defillama data also indicates that the scale of liquidity pools operated by Curators has shrunk by nearly $3 billion since the beginning of the month. It is clear that funds have reacted to the current situation through their actions.

DeFi is also subject to the classic "impossible triangle" of investment markets ------ high yield, safety, and sustainability can never be satisfied simultaneously, and the current factor of "safety" is teetering on the brink.

Perhaps you have become accustomed to investing funds into a certain stablecoin or strategy for yield, and have achieved relatively stable returns through this operation over a long period. However, even products that consistently adopt the same strategy do not have a static risk profile; the current market environment is one where risk factors are relatively high and unexpected incidents are most likely to occur. At this time, caution is paramount, and a timely withdrawal may be a wise choice, as when a low-probability event occurs to oneself, it becomes 100%.