Image by Ideogram
Recent events tied to World Liberty Financial (“WLFI”) seem eerily similar to the FTX failure from a few years ago.
FTX had created its own token FTT as a way to raise capital and provide liquidity to the FTX markets. Fees could be paid in this currency which FTX would collect and then sell back into their open market.
The problem with FTX was that they could freely mint as many FTT tokens as they wished and they allowed Alameda, an affiliated company, to borrow against FTT tokens. The FTT token was not backed by anything, it relied entirely on a functioning market as well as a limited supply.
So when Alameda borrowed a lot of capital in the FTX platform using FTT as collateral, it had quite literally printed free money for itself. Once the market took notice, the value of FTT collapsed and Alameda and FTX were unable to settle their debt obligations.
WLFI used their own token to borrow their own stablecoin; roughly 2 billion WLFI were used as collateral to borrow about 31 million USD1 stablecoins. They used Dolomite, a lending platform, to execute the deal.
The problem here is that anyone who deposited USD1 in Dolomite is effectively locked out from withdrawing their entire balance; there is less USD1 in Dolomite than receipts for USD1 deposits.
This will not change unless a large amount of the borrowed USD1 is repaid. If the price of the WLFI token crashes and the position gets liquidated, that liquidation could cause the price to drop further which could make the deposit receipts worthless.
This highlights an ongoing problem with decentralised finance (“DeFi”), wallets with large balances (otherwise known as whales) are capable of manipulating markets, draining liquidity, and locking protocols.
A bank would never let one entity, no matter how capital rich it may be, borrow heavily to acquire a different asset and then move the borrowed asset externally; especially if the collateral asset was the entity’s own asset like shares or bonds.
With DeFi however, this is entirely possible and very difficult to control. Even if an upper boundary is set for borrowing, there is nothing stopping a whale from using multiple addresses to avoid any limitations.
Ideally, DeFi protocols should actually cap the amount of total collateral it holds for each token. They should be designed to make it prohibitively expensive to use a token as collateral if the protocol already has a lot of that same token.
In a perfect world, the DeFi protocol would also have some form of risk weighting baked into its protocol.
The problem is that for your average DeFi user, how do you even assess concentration risks and liquidity risks before using a protocol. Seasoned DeFi users may know what key metrics to look at and would probably tell anyone new to the space to “do your own research”; however, there is an expectation that a lot more people will start using blockchain protocols in the near future and they will not know where to start when it comes to researching anything.
Image by Ideogram
I expect most people will be drawn into various protocols with the promises of large yields.
Yields are a very hot topic just now in the blockchain space; the CLARITY act in the US was nearly derailed because of discussions around yields.
The GENIUS act and the CLARITY act are expected to increase blockchain usage by new users. Banks and large companies will be able to create their own stablecoins. Stablecoin payments are expected to be faster and cheaper than conventional payments.
Currently, most stablecoins do not charge fees because they make more than enough money from the yields generated with the underlying cash. Most of the cash is converted into US treasuries or deposited into money market funds since they can be relatively liquid, do not fluctuate wildly in price, and pay a yield.
With the expected avalanche of new stablecoins, the market is about to get very crowded and competitive. To give themselves a competitive advantage, some stablecoins will start to offer yield. This is a fascinating idea since by definition, the price of these coins is fixed to another asset (usually US dollars); by offering yield, the perceived value of these tokens could be higher than their actual price.
But I actually want to focus on the mechanics of paying yield because I think this is where risks may be missed.
First of all, it would be very difficult to offer the ability to pay yield directly to all token holders based on their wallet balances. Presumably the yield will be paid in the stablecoin itself and the tokens would be minted to all the wallets of holders.
The standard ERC20 token contract does not maintain a list of all token holders, this is usually derived by monitoring transfer events externally.
Also, smart contracts cannot automatically generate transactions, they have to be externally triggered.
So every time a yield payment is made, a transaction will need to be submitted in order to instruct the smart contract to mint or transfer tokens to a given address. Even if these transactions are bulked together, it will require a large amount of gas; those fees are likely to be deducted from the yield payment.
The frequency and amount of yield payments would be difficult to manage as well. If someone briefly holds the stablecoin between two spot trades, do they get paid?
For the companies promising stablecoins with yields where you retain control of the token, they will likely require that a user register their wallet with them and maintain a minimum balance. That way the onus is on the user to ensure they are included in the list of eligible wallets instead of the institution or smart contract managing that list.
Another possible yield model would be to require that a user stakes the coin. Their staked coins would then be paid a yield but effectively locked from use. The staking contracts may even enforce a delayed withdrawal. This could happen even unintentionally if the staking contract does not hold all of the staked stablecoins at all times, much like what has happened with Dolomite and USD1.
A third possibility could be that yield is only paid to exchanges and institutions that choose to participate in a program offered by the stablecoin issuer. This would require users to hold the stablecoin in a custodial wallet to get whatever yield is passed on to them. It also means that the users do not actually own the tokens or the rights to the yields, they just have beneficial rights to both.
So while there may be a lot of stablecoins coming to the market soon that will offer yields, a lot of them will probably over promise and under deliver. They will not increase liquidity but instead reduce the apparent liquidity since payment will likely depend on the coins not moving.
The promise of yields may be alluring but the mechanics of paying that yield either requires a lot of regular transactions being submitted or the locking of the funds somewhere.
If these coins do need to be locked in somewhere, then that location is a centralisation risk whether it is a smart contract or a custodial wallet.
If a company is offering very high yields, then there is a good chance that they plan to use riskier assets since treasuries and money markets will only ever generate a few percentage points.
Be sure to read the full terms of any stablecoin promising yields.
So beware of promises of yields because there may be a lot of underlying risk and the mechanisms to get these yields could become liquidity traps.
Beware of Liquidity Traps and Promises of Yield was originally published in Coinmonks on Medium, where people are continuing the conversation by highlighting and responding to this story.