As usual, none of the following is financial advice.
After last week, it should be abundantly clear to everybody at this point is that cryptocurrency is very risky. Users of Terra believed they were somewhat playing it safe. Trading $LUNA for $UST was flipping between two tokens that appeared to be top ten cryptocurrencies by market cap. They were following the smart money: aping in along with top investors and VCs.
Yet it all disappeared in the span of days.
For the median Terra user, the behavior was roughly the same as the behavior of the median Ethereum user. While Terra had way more warning signs than Ethereum, users dismissed them. Is this any different than Ethereum users dismiss the rantings of Paul Krugman types? Ethereum users could just as easily see it all disappear overnight, and instead of bailouts we’d get haters gloating “I told you so.”
As self-described Curve/Convex maximalists, we remain extremely bullish on the flywheel. Yet we’re also quite prepared for the event that all our blockchain assets simply evaporate overnight. Yes, we’d be stunned and have a lot more free time, but life would continue uninterrupted.
If you would not be OK in the event Curve evaporated, you have no business using Curve.
If you would not be OK in the event ETH evaporated, you have no business using ETH.
Get your basics right first, then you can play at the casino with the funny money. Unlike $UST, Curve isn’t even a top 10 token by market cap. You think anybody’s coming to save you in the event of a collapse?
With this in mind, we wanted to release some notes on under-discussed risk factors in using Curve. This list is not exhaustive and doesn’t discuss some risks (ie hack risks, rug pulls, etc.) It’s meant to be some issues of real concern that deserve more discussion. Please do this sort of due diligence before using any site within DeFi.
Shallow Pools
The impressive moat Curve has built up is often touted as a bulwark against competition. Curve has billions in TVL. Top of its class on DeFi Llama. This must give LPs some protection!
What protection does Curve’s sea of liquidity provide? As it turns out, less than one week in a panic.
Along these lines, Curve 3pool was considered a safe harbor. It was bottomless. A backbone of DeFi.
The time it took to imbalance the pool? May 7 to May 13:
One week of panic and the base layer of DeFi got clogged for whale-sized transactions. We presume the pool does rebalance given the tight peg all these assets have. It’s just a reminder that these moats are shallower than they seem.
All the attention on DeFi, yet our entire industry is smaller than MUFG Union Bank.
Depeg Risks
This risk is better understood following $UST’s horrendous depeg. Users hopefully have an idea that “stablecoins” are not always stable. While the assets in 3pool are all considered “safer” than $UST because they tend to be backed 1:1 and have a longer reputation for stability, one can imagine scenarios where they temporarily or even permanently lost peg.
Most stablecoins consist of stronger stuff than $UST. The aforementioned 3pool contains arguably the three safest stablecoins in DeFi. Tether, the largest stablecoin, has survived despite years of FUD. It’s been processing redemptions 1:1 without incident. The 1:1 backed coins are unlikely to depeg.
Several stablecoins are less resilient.
Given a marginal shock to DeFi, several of these coins could implode, causing something of a chain reaction. Which brings us to the most likely spark…
Regulatory Risk
We know regulation is coming. We also know stablecoins are right in the crosshairs of regulatooors.
It might seem ridiculous to the casual observer. $UST is a stablecoin outside of US jurisdiction operated by non-US citizens. Yet western governments are acting?
Remember though, much of the USA’s global power is built on dollar dominance, a footing that has been eroding lately.
Although the high IQ move would be to embrace dollarcoin dominance in DeFi, bureaucrats are not terribly bright. If you don’t expect governments to fight viciously on this front, take some time to re-read Sovereign Individual.
DeFi could, and might still, forestall this attack by moving to coins not denominated by the US dollar.
Unfortunately, the dollar is a popular unit of account globally, because you know the number of dollars needed to buy your lunch ticks up somewhat predictably between 1-25% per year so you can plan accordingly.
So what might regulation look like? Too many scenarios to address them all in this article.
There’s some reason to think somewhat level heads may counterbalance the doomsday scenarios. In the US in particular, a midterm election is coming up. How much do they want to damage an already weak economy right before voters head to the polls?
Hand-wringing about regulation exposes our American-centric perspective. Check the recent interview with Charlie, in which he expressed very little concern about regulatory issues. Switzerland’s environment is quite different from the US. The official meatspace entity behind Curve (which exists for things like protecting IP) has done loads of legal work to make sure everything comports with applicable laws.
So it is quite unlikely Curve simply gets “shut down.” Even in the unlikely case the official entity got hammered, this would do little to halt the underlying protocol. The website (hosted on IPFS) and the web of smart contracts will keep operating in perpetuity, provided the DAO remains actively involved in governance and users keep launching pools. Uniswap has still transacted while under investigation by the SEC, and Curve is far more decentralized and resilient.
Regulatory efforts may try to put the dampers on Curve, or blunt its growth prospects by implementing harsh regulations. It could choke off capital from meatspace entities. However Curve has done OK without meatspace entities to date. Such regulations might cause some turbulence in the speculative value of Curve’s DAO Token, but little impact on overall operations.
So along the spectrum of possibilities, most regulatory efforts might prove relatively innocuous. However, users should be cognizant of the most extreme form of regulatory risk. In the event that Western governments decide to go nuclear, we might find ourselves facing a severe reshuffling of the entire DeFi landscape….
Blacklist/Whitelist Risk
If governments take the most nuclear approach, they may strictly enforce the blacklist capabilities built into the top stablecoins.
Hypothetically, the government could order USDC (the closest thing to a CBDC) to prohibit any interaction with any contracts they found offensive. There’s many ways they could implement such a nuclear scenario. The attacks would all likely take a similar form: restricting transfers to specific addresses, but not transfers from these addresses. In other words, you might be able to withdraw out of a Curve pool, but it would not be possible to get in.
Would governments take such draconian actions? It’s always been presumed unlikely, in part because the consequences would be so devastating and the backlash would be intense. Yet governments have performed a litany of horrendous actions in their past, so it has to be considered as a possible risk factor.
In the event a blacklist, or an even more devastating whitelist, were enforced, what is the risk to Curve users? Here’s my purely speculative take on how the most extreme blacklist/whitelist would play out:
The initial shock will be drastic. You would expect to see 3pool dry up to six to eight figures worth of TVL. Every pool built on top of 3pool would be forced to relaunch or dry. Yet this swift collapse would not ultimately be an existential risk to Curve.
The initial outflow will play out quite quickly. A healthy chunk of the liquidity that flowed out of Curve’s old pools would find its way into newer pools that were unaffected. Some of the more decentralized stablecoins would pounce on the opportunity. Surviving pools like d3pool would push themselves as the new base pairings. These newer pools would become a more resilient framework on which to build the next generation of Curve pools. After the short term pain, the new foundations DeFi would emerge. Within about a month, the new DeFi would be stronger than ever.
However, the short term pain would be severe. This speculative scenario would involve a lot of blood for any LPs in the existing pools. In the rush to escape, some users would find themselves bagholding coins that depegged and became effectively worthless. We saw how quickly Curve’s liquidity can migrate ($10B in the past week). Regulations targeting Curve specifically would cause an even greater panic. By the time regular users tried to react it would already be too late. The protectoooors will have bankrupted users to the tune of millions or possibly billions of dollars.
We can also expect in the long run these actions backfire spectacularly against the regulators. Their nerfed stablecoins would now be “protected,” but few people would now actually have any interest in using it. These coins could only access low-yield on-chain bank products that didn’t recoup the gas costs. Nobody would be interested. In this way, the rollout of regulatory-friendly stablecoins would parallel attempts to roll out a Chinese digital yuan, which failed to gain adoption because it was not useful to users.
Meanwhile, the talent and wealth would quickly migrate to friendlier countries at spectacular speed. Faced with a still thriving and more decentralized stablecoin industry that was tougher to regulate, politicians will have harmed their own citizens with nothing to gain. Swept out of office within a few years, the incoming class may softpedal or reverse these regulations. At this point it’s too late though. DeFi has already been rebuilt with even greater decentralization.
Again, this is one speculative story. What actually happens in the doomsday scenario may shake out entirely differently. We construct this by noting that DeFi today has been shaped largely in response to the ICO crackdown of a few years back. Another major crackdown is likely to follow a similar trajectory: short term harm the industry, but ultimately the industry reshapes itself and rebuilds stronger in response.
We don’t have any inside knowledge as to the likelihood of what specific types of regulation may hit, or when it may hit. Based on public comments, we would guess it will be released in the next few weeks to months. We’ll also guess that a similar regulatory structure will be announced across several western countries at nearly the same time. We’ll also guess the market tumbles again when it happens. Check back with us at the end of 2022 and let us know how we did.
If you can’t afford to weather severe changes like the above story, you may want to stay on the sidelines.
For what it’s worth, the writers at the DeFi Education Substack are recommending exactly this. They have a great read of the landscape, and have recommended yield farming opportunities like Curve in the past. At the moment, they recommend staying clear of everything.
This is just a small snapshot of their list of recommendations from the paid post (shared with permission). If you need a great place to park $10/month worth of stablecoins, a subscription to their Substack should be high on your list (author was not compensated to say this).
Risk On
Our puny Substack already has plenty of enemies, so we really hate writing a post like this which could hand them more ammunition. Hopefully fans know by now we’re not here to spread FUD about Curve. Quite the contrary, we want to make sure that all of Curve’s users are making intelligent, informed decisions that keep them protected in the event of horrible downside risks. By openly discussing the risks, we hope our boosterism ultimately gives us more credibility.
So what can you do? In this world without absolutes, literally nothing is safe. Put your money into a bank? That’s easily at risk of getting seized. Onto a centralized exchange? You own nothing. Stash it under your mattress? Losing purchasing power each year thanks to inflation.
No easy answers unfortunately. Financial advisors (aka not us) like to talk about diversification. The comfiest positions is quite likely spreading into a variety of investments, including assets on different blockchains (owning both BTC + ETH is more resilient than just one of them). On-chain, try putting money into different protocols. Keep some money off-chain, including exposure to TradFi. If you don’t have a steady flow of income, try to find some work to keep you safer during any potential upcoming chaos.
To close out this gloomy post, let’s balance the risk factors with the opposing view. If you are in a situation where you feel you are well-diversified and can absorb a higher level of risk, you may look at the above risk factors and smell opportunity.
When there is no risk, you can expect little yield. In contrast, if enough people are scared away from DeFi because of these risk factors, you may find tremendous opportunity by being the only person running towards DeFi.
So if you’ve considered the risks and are still so unhinged as to be pursuing yield opportunities in DeFi, let us know in the comments where you’re looking! We’re putting together a post on the subject and would love to hear your thoughts.
Disclaimers! Despite the FUD in this article, author maintain exposure to some Curve pools and DeFi yield farming opportunities.