The systemic risk of the on-chain wealth management system has exploded. Why do I strongly recommend that you temporarily withdraw?

Original Title: “On-Chain Wealth Management, Danger! Run Away!”

Written by: Azuma (@azuma_eth), Odaily Planet Daily (@OdailyChina)

DeFi is once again in the spotlight.

As one of the most vibrant narrative directions in the industry over the past few years, DeFi carries the expectations for the cryptocurrency industry to continue evolving and expanding. Believing in its vision, I am accustomed to deploying over 70% of my stablecoin positions into various on-chain yield strategies and am willing to take on a certain degree of risk.

However, with the recent fermentation of multiple security incidents, the collateral effects of some historical events, and the gradual exposure of inherent problems that were originally hidden underwater, a dangerous atmosphere has pervaded the entire DeFi market. Therefore, the author of Odaily chose to consolidate the majority of on-chain funds last week.

What exactly happened?

First Half: Opaque High-Interest Stablecoins

Last week, several security incidents worth noting 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), revealed some fundamental issues.

The common point between xUSD and USDX is that both are packaged as a synthetic stablecoin similar to Ethena (USDe), primarily utilizing delta-neutral hedging arbitrage strategies to maintain their peg and generate returns. Such interest-bearing stablecoins have flourished in this cycle, and due to the simplicity of the business model itself, along with the prior successful case of USDe, various stablecoins that have emerged in bulk have even attempted every combination of the 26 English letters with the word USD.

However, many stablecoins, including xUSD and USDX, have reserve and strategy conditions that are not transparent enough, but under the stimulation of sufficiently high yields, such stablecoins have still attracted a large inflow of funds.

In relatively calm market fluctuations, such stablecoins can still maintain operation, but the cryptocurrency market always experiences unexpected large fluctuations. According to Trading Strategy analysis (refer to “In-depth Analysis of the xUSD Decoupling Truth: The Domino Crisis Triggered by the October 11th Crash”), the main reason for the significant decoupling of xUSD is that Stream Finance's opaque off-chain trading strategy encountered the exchange's “Automatic Deleveraging” (ADL) during the extreme conditions on October 11th (for a detailed explanation of the ADL mechanism, refer to “Detailed Explanation of the ADL Mechanism in Perpetual Contracts: Why Your Profitable Order Can Be Automatically Liquidated?”). This led to the original Delta-neutral hedging balance being broken, while Stream Finance's overly aggressive leverage strategy further amplified the impact of the imbalance, ultimately resulting in Stream Finance's substantial insolvency and the complete decoupling of xUSD.

The situation of Stable Labs and its USDX should be similar, although its official announcement later attributed the depegging 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, even preferring to bear an abnormal cost of over 100% in interest rather than repaying, the situation of this protocol may be even worse.

The situation of xUSD and USDX exposes serious flaws in the emerging stablecoin protocol model. Due to the lack of transparency, such protocols have a significant black-box space strategically. Many protocols claim to be delta-neutral models when promoting themselves externally, but the actual position structure, 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.” In essence, they become a party that bears the transferred risks.

A classic scenario of such risk eruption is when users invest mainstream stablecoins like USDT and USDC to mint emerging stablecoins like xUSD and USDX, in order to earn attractive yields. However, if something goes wrong with the protocol (and we need to differentiate between real issues and staged events), users will find themselves in a completely passive position, as their stablecoins will quickly decouple under panic selling. If the protocol is reputable, they might allocate remaining funds for compensation (even if compensation is provided, retail investors are often paid out last), while in less reputable cases, it could lead to a soft exit or be left unresolved.

However, it is also biased to categorically dismiss all Delta-neutral income-generating stablecoins. From the perspective of industry expansion, emerging stablecoins that actively seek diverse income paths have their positive significance. Some protocols, represented by Ethena, will provide clear disclosures (Ethena's recent TVL has also shrunk significantly, but the situation is somewhat different; Odaily will write another article to elaborate later). However, the current situation is that you do not know how many protocols with insufficient or undisclosed information have encountered problems similar to xUSD and USDX. — When writing this article, I can only assume innocence due to a lack of evidence, so I can only use 'explosive' protocols as examples. However, from the perspective of ensuring your own position's safety, I would recommend you to assume guilt until proven innocent.

Second Half: Lending Agreements and Fund Pool Curator

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 the DeFi ecosystem - modular lending protocols and Curator (the community seems to have gradually gotten used to translating it as “master”; Odaily will directly use this translation in the following text).

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 it be a hidden risk in this cycle?” Those interested can read it directly, and those who have already seen the original text can skip the following paragraphs.

In short, professional institutions such as Gauntlet, Steakhouse, MEV Capital, and K3 Capital will act as managers to package some relatively complex yield strategies into user-friendly funds on lending protocols such as Morpho, Euler, and ListaDAO, allowing ordinary users to deposit mainstream stablecoins like USDT and USDC with one click on the front end of the lending protocols to earn high interest. Meanwhile, the managers will determine the specific yield strategies for the assets on the back end, such as allocation weights, risk management, rebalancing cycles, withdrawal rules, and so on.

Due to the fact that such liquidity pool models often provide more substantial returns than traditional lending markets (like Aave), this model has naturally attracted a surge of funds. Defillama shows that the total size of liquidity pools operated by major custodians has rapidly grown over the past year, surpassing $10 billion at the end of October and early this month, and as of the time of writing, it still reports $7.3 billion.

The profit path of the principal mainly relies on performance sharing and management fees from the fund pool. This profit logic determines that the larger the scale of the fund pool managed by the principal and the higher the strategy return rate, the greater the profit. Since most deposit users are not sensitive to the brand differences of the principals, the choice of which pool to deposit into often depends solely on the apparent APY number. This means that the attractiveness level of the fund pool is directly linked to the strategy return rate, so the return rate of the strategy becomes the core factor that ultimately determines the profit situation of the principal.

Under the business logic driven by yield, coupled with the lack of a clear accountability path, some principal actors gradually blurred the safety issues that should have been considered first, choosing to take risks – “After all, the principal is the user's, and the profits are mine.” In recent security incidents, it was MEV Capital, Re7, and other principal actors who allocated funds to xUSD and USDX, thereby indirectly exposing many users who deposited through lending protocols like Euler and ListaDAO to risks.

The burden cannot be solely borne by the party in charge; some lending protocols are equally to blame. In the current market model, many deposit users do not even fully understand the role of the party in charge, but simply think they are just investing their funds into a well-known lending protocol to earn interest. In fact, the lending protocol plays a more explicit endorsement role in this model and also benefits from the dramatic increase in TVL achieved through this model. Therefore, it should take on the responsibility of monitoring the strategies of the party in charge, but clearly, some protocols have failed to do so.

In summary, a classic scenario of this type of risk is that users deposit mainstream stablecoins such as USDT and USDC into the lending protocol's liquidity pool, but most are actually unaware that the managers are using the funds to operate yield strategies and are not clear about the specific details of the strategies. The back-end managers, driven by profit rates, then deploy the funds into the emerging stablecoins mentioned earlier; after the emerging stablecoins crash, the liquidity pool strategy becomes ineffective, and deposit users indirectly bear the losses. Following that, the lending protocol itself experiences bad debts (it seems that timely liquidation would have been better, but forcibly locking the oracle price of the de-pegged stablecoin to avoid liquidation could actually exacerbate the problem due to large-scale hedging borrowings), leading to more users being implicated… In this pathway, risks are also being systematically transmitted and diffused.

Why has it come to this?

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

Traditional institutions only favor a very small number of mainstream assets; altcoins continue to plummet, with no bottom in sight; the meme market is rife with insider manipulation and algorithmic trading; coupled with the massacre on October 11… a large number of retail investors have merely been participating in this cycle or even facing losses.

Against this backdrop, the seemingly more certain path of wealth management has gradually gained larger-scale market demand. Coupled with the milestone breakthroughs in stablecoin legislation, a multitude of emerging protocols packaged as interest-bearing stablecoins have appeared in bulk (perhaps these protocols shouldn't even be called stablecoins). They extend an olive branch to retail investors with annualized yields that often exceed a dozen or even several dozen points. Among them, there are certainly high achievers like Ethena, but there are also inevitable mixed fortunes.

In the highly competitive market of yield-stablecoins, to make the product's yield more attractive — it does not need to be sustained long-term, just maintain better data until the issuance or exit — some protocols 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 their managers perfectly address some users' psychological barrier regarding unknown stablecoins – “I know you're not comfortable depositing your money as xxxUSD, but you're depositing USDT or USDC, and the Dashboard will also show your positions in real-time. Can you still be uneasy about that?”

The performance of the aforementioned model has been fairly good over the past year or so, at least without any large-scale blowups over a longer period. As the overall market is in a relatively upward phase, there is enough foundational arbitrage space between the futures and spot markets, allowing most interest-bearing stablecoin protocols to maintain relatively decent yield performances. Many users have also let their guard down during this process, and double-digit stablecoin or fund pool yields seem to have become the new normal for wealth management… But is this really reasonable?

Why do I strongly recommend that you withdraw temporarily?

On October 11, 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 running long-short hedge strategies had suffered significant losses, but it was unclear who had lost the most.

In hindsight, the series of collapses of so-called Delta-neutral protocols like Stream Finance partially corroborates Evgeny's speculation, but we still do not know how many hidden dangers remain underwater. Even for those not directly affected by the liquidation blow on that day, the market liquidity quickly tightened after the massive liquidation on 1011, coupled with the contraction of arbitrage space due to the cooling market sentiment, which would increase the survival pressure on yield-bearing stablecoins. Various unexpected incidents often occur during such times, and due to the complex interwoven relationships that often exist in opaque funding pool strategies at the underlying level, the entire market is prone to a situation where “pulling one hair affects the whole body.”

Stablewatch data shows that as of the week of October 7, interest-bearing stablecoins experienced the largest outflow of funds since the collapse of UST during the Luna crisis in 2022, totaling 1 billion USD, and this outflow trend is still ongoing; moreover, Defillama data also indicates that the size of the liquidity pools managed by operators has shrunk by nearly 3 billion USD since the beginning of the month. It is clear that funds have reacted to the current situation with their actions.

DeFi also applies to the classic “impossible triangle” of the investment market — high yield, safety, and sustainability can never be satisfied simultaneously, and currently, the factor of “safety” is on shaky ground.

Perhaps you have become accustomed to investing funds into a certain stablecoin or strategy to earn interest, and you have received relatively stable returns through this operation over a long period of time in the past. However, even products that always use the same strategy do not have a static risk profile. The current market environment is a window where the risk factor is relatively high, and unexpected incidents are most likely to occur. At this time, caution is the best policy, and retreating at the right moment may be a wise choice. After all, when a low-probability event happens to oneself, it becomes 100%.