I wrote about a deeply exploitive scam called The Billion Coins. Unfortunately, that coin is still active and is still taking advantage of people. They have tried to rebrand to make themselves look more official, but are still the same group of scum.
I once wrote about a worthless token called slidebits. Now the creator himself removed the blockchain from his app.
I wrote an article presenting a bearish case for a token when I was applying to a crypto hedge fund. That token has a market cap 1/10 of it’s all time high. Though I must admit, it has not seemed to be affected by any of the issues I pointed out. Sometimes things just break your way.
If there is one thing that crypto can regularly provide it is drama. Today, the controversy (or at least one of them) centers around a token called Few. The token seems to have started when Sam Ratnakar decided to invite a small number of influential people from cryptocurrency to work on an “Experiment”. Each would receive an equal proportion of the tokens and a small proportion would be reserved for liquidity.
Many members of the telegram who received the token seem to have an honest desire to build something. However, the Telegram was also quickly filled with ‘jokes’ about pumping and dumping the token.
Now let’s give all of these people the benefit of the doubt and assume they were working honestly with the goal of building something important. Even still they are doing it in what seems to be an inexplicable manner.
Generally, tokens should be created in order to serve a purpose. You decide on a project, a protocol, something, that in order to function optimally requires a token. What happened instead here seems to be that the token was created, distributed to a list of people with influence in crypto, many of them started “jokingly” shilling it on Twitter, and there was still no reason for the token to exist.
My intuition, and I hope I am wrong, is that the earliest creators and shills of $FEW were not doing it entirely as a joke. I believe many of them were experiencing FOMO (Fear Of Missing Out) and in order to rectify that feeling settled on creating their own token, airdropping it to a small group of influencers, and then “influencing”, so that they too could share in the mania.
Even if it was all a “joke”, where’s the punchline? Is it a meta point that most tokens are worthless? Is it a commentary on the large amounts of wealth that generally accrue to the earliest and most connected in crypto? Is it supposed to be a mockery of the “great team” method of crypto investing? None of those feel convincing to me, and I am left with a sadness about the state of cryptocurrency.
There is an obsession passing through crypto over ‘yield farming’. I have very little idea what yield farming is. In order to learn what it is I am going to look into a coin that recently launched that I saw people tweeting about called Kimchi. I chose this coin as it came out the same day that I made my first batch of kimchi. This post will be a log of my trying to understand this coin.
First, I need to figure out what is yield farming. As far as I can tell yield farming works by placing your token into a Uniswap (or similar auto market maker) contract that is against a dollar equivalent (often Tether or USDC). In order to understand the impact of this I have to zoom out again and refresh my memory of how Uniswap pools work.
[Aside I learned while researching this: Tether and Binance violate the ERC-20 standard by not returning an integer boolean when transfer() is called and both instead return nothing.]
Each pool consists of two ‘ERC-20’ tokens (as discussed above they do accommodate some non standard implementations) (this also means that the contract does not natively handle Eth and instead must use WEth which is ether wrapped in an ERC-20 compliant token). When you make a swap in this pool the token you transfer is exchanged for the proportional value of the other token in the pool. Say there is 1 Eth in the pool and 100 USDC and you swap 0.05 Eth then you will receive 4.747 USDC. This amount may seem odd at first glance, but Uniswap charges a 0.3% fee on the trade which is paid out to those who have contributed their assets to the pool. (Note: this examples ignore gas fees)
So now we need to zoom out slightly more and focus in on the liquidity providers. The way these pools work is that you deposit your tokens to the contract as a liquidity provider and then are paid a liquidity token which represents your proportional ownership of the fees for that contract. This token can be transferred, traded, and lent (this is where some of the more complex interactions come into play) and to receive your payout of the liquidity fee your liquidity token must be burned. On contracts with decent volume you can receive meaningful returns from contributing your tokens to the contract and thus people are incentivized to contribute to further liquidity.
Okay now I feel like I have a strong enough understanding of these systems to actually look at the token in question Kimchi. In the past when assessing new contracts my instinct has always been to read the whitepaper, however Kimchi and many other of the ‘new’ tokens do not have whitepapers. So that stymied somewhat, however Kimchi does tell us it was forked from Sushi and Yuno. I was optimistic that one of these would have a whitepaper. They do not. Sushi however does have a Medium post. Perhaps that will help us understand their system.
The first change is that the liquidity token provided in Uniswap is replaced with a Sushi token that gives an ONGOING right to fees deposited into the contract. I emphasized that in case any securities lawyers come across this article. The way this works is that the majority of the liquidity fee is distributed to active liquidity providers in the same way that it is with Uniswap, but a small portion of it (1/6) is converted to Sushi and issued proportionally to Sushi stakers. Every block Sushi are minted and 90% are distributed to Sushi stakers and the remainder go to the ‘Dev Fund’.
Now we can shift back to Kimchi and try to figure out how it differs from Sushi. First, they mint more tokens in each block. Second, they offer preferential rewards for some pairs. Looking around on Twitter it appears that YUNO the other token they forked from had a backdoor, and Kimchi preserved that backdoor but made it impossible to exploit by tying it to a non-functional contract. https://twitter.com/emilianobonassi/status/1300925536747876354
This also means that there is no real governance or changes that can happen with Kimchi, whereas Sushi claims to be working on governance.
Now we need to zoom out one more time and look at yield farming as a whole and why these tokens are popping up in the first place. Many different DeFi products like Compound issue governance tokens to users and this has incentivized a large amount of liquidity to flow into them. Furthermore, there are people who will contribute their token to liquidity on Compound, and then use the resulting token representing their lent token on Compound as liquidity on Uniswap (or Sushi or whatever). The ability for the same collateral to be used in multiple places, and producing yields in multiple places that can then also be used to generate yield seems to be the basis of yield farming.
My fundamental and deep seated issue with all of this is that this all seems to be happening with such speed that any kind of due diligence is skipped. There are no whitepapers. There are no security audits. There is no community due diligence before money starts pouring in. Many of these contracts have admin keys that allow for the creators to mint a large amount of tokens, to remove liquidity, to change the contract in other ways. This does not seem to be the future of money, but instead a mad cash grab built with the assumption that the black swan will never happen. That the stacked yields won’t eventually succumb to abnormally large withdrawals, or exploits, or extraordinary market conditions. Inevitably they will. I hope every single person with funds committed to them are fully aware of that risk.
So I recently did a pretty broad breakdown of stablecoins. When I was going back over it, I realized that I wanted to dive really deep into some of these and so I am going to start with Dai, and I am going to do it by going step by step through their whitepaper and giving my thoughts and potential problems with it.
First of all what is MakerDAO: it is the “Decentralized Autonomous Organization” that governs DAI.
What is DAI?: It is a soft pegged stablecoin.
What is a soft-pegged stable coin?: It is supposed to be near a certain value, but is allowed a degree of flexibility.
What is MKR?: MKR is a separate token used in the DAO to govern Dai and also to pay the “stability fee” which is the annual fee you pay to get your Dai.
Okay so that’s a lot of moving pieces, and as I have already discussed in my previous article there are issues in general with the concept of stablecoins. But without further ado let’s take a look at this whitepaper and see if there are any issues.
Okay, I can buy this so far, that’s a very fair opening argument.
Okay now we are starting to get into problems. It is going to be really hard for any collateral-backed cryptocurrency to keep a stable value relative to the US Dollar, unless the collateral backing it is the US Dollar. Otherwise we are going to be vulnerable to changes in the value of our collateral that are not reflected in changes in the value of the dollar. Also they never explain why it is necessary to realize the full potential of blockchain, but ignoring the grandiose marketing speak masquerading as technical language, we soldier on.
The issue here is appropriately incentivizing external actors. Namely it’s a really hard thing to do without accidentally introducing perverse incentives, but maybe they were able to do it.
First question, why would any in their right mind hold it for savings? Either directly hold your collateral or hold fiat. That is not a use case for a stablecoin. Also here we are bumping against an issue both I and the developers have acknowledged, we are not collateralizing with USD, but instead with Ethereum, and as the developers explained Ethereum is too volatile to be used as a currency, which means for this to work we are going to need to over-collateralize. Meaning if you want say $100 worth of Dai you will need to put up significantly more than $100 worth of Ether. Which makes it hard for me to figure out why someone is going to choose to do this.
So here we see where they say you need to have more collateral than Dai. They also say that you need to pay back an equivalent amount of Dai, and that is true, but what they have not explained yet is that you also need to pay a stability fee in MKR, their other token. Also they cannot always be collateralized in excess, because if there is a black swan event that destroys the value of Ethereum that is no longer true.
Here we finally get the mention of the “Stability Fee” which has to be paid in their MKR token.
It’s been six months and they still have not launched Multi-Collateral Dai, but they do still have time so that is not a true criticism.
This is my favorite part of the entire whitepaper. So I have mentioned how even with the overcollateralization this is still very vulnerable to a black swan event that destroys the value of Ethereum. This part is where they say they in the event of this crash they will dilute the “Pooled Ether” which means that when you go to reclaim your Ether you will not even be receiving the full Ether you put in (if I’m understanding this right). Why someone would trust this, I do not know. The developers are obviously aware of this risk, but it seems to be ignored.
This is where we start to look at their incentives to determine whether they designed intelligently. These are just definitions so do not help us a ton. Just a warning this next part they try to obscure what they are doing with really technical language, but I am going to do my best to break it down.
So best as I can understand this section, when Dai falls below $1 what happens is that generation of new Dais becomes more expensive, meaning require greater collateral. They hope this restriction on new supply and the knowledge that presumably this should be worth about $1 means that there will also be increased demand below this point. Then when it breaks above $1 it now requires less collateral to generate Dais and presumably people are less likely to want them. My biggest fear here is in the case of a serious, say 40% 1 hour movement in the value of Ethereum. You are going to have people selling their Ether, possibly into Dai if it is trading in a pair, creating a strong demand driving the price of us, at this same time it is now easier to collateralize and create more Dais, but the value of the collateral is rapidly depreciating, thus leading to a greater likelihood of Dai becoming under-collateralized. If I am misunderstanding this mechanism however please reach out and help me.
Intuitively, I feel like this is a value that is going to need to be set very careful, because otherwise I worry about appropriately capturing signal and noise.
Now this is again where things get really interesting. Basically shuts down the whole system and gives them their share of the “pooled ether”. Problem with it? If it is being used there is a very good chance that Ether is now worth much less than your Dai was supposed to be. The term “long term market irrationality” to me feels like their hedge against the chance that crypto prices fall and they have no recourse.
Basically saying what I said. This is the ripcord they pull when they are giving up because they are no longer collateralized.
So now we are starting to get into the MKR token and what powers it gives in the DAO. We have already discussed some of these, but you can see how these are very important decisions.
The important thing here is the liquidation ratio. This will help us figure out how likely it is that the whole house of cards falls down.
So the stability fee like I have mentioned is the annual fee you pay for the privilege of having your collateral tied up by them. The penalty ratio is a little bit more confusing to me. As I understand it, if the value of your collateral gets to close to the value of your DAI it is automatically liquidated and then it used to buy up MKR when we have the multi-collateral system, but for now it looks like it burns the “Pooled Ether” which helps if it had to be diluted previously. This is honestly clever. I need to give props to this. If I am understanding it right it can help Dai survive pretty significant corrections, but I am dubious about a black swan event.
This part is endlessly fascinating to me. Apparently the plan with multiple assets is to sell off MKR whenever they become under-collateralized. The issue here is the legal issues with basically continuing ICO sales. Plus, I feel like this gums up the works economically, but I cannot put my finger on why yet. Best I can come up with is this: MKR is likely to be highly correlated to other crypto assets, the need for this dilution would arise in a situation wherein the value of MKR is already depressed due to a crypto crash, this market condition will require huge amounts of dilution to raise the funds necessary to recapitalize. It also makes it interesting, because it’s a constant downward pressure on the governance token, potentially making it easier for people to start influencing the DAO, but that of course depends on how the holding of MKR shakes out.
So first question how is every Ether backed CDP not a risky CDP? But basically as I understand it sometimes they will force liquidation of the underlying asset to preserve the value of the Dai. The issue here could be if enough sales are triggered simultaneously, and they are selling into thin liquidity.
Again look at the last paragraph here. Our biggest issue is going to be events where the market moves fast and suddenly. They’re going to get caught in some ugly dilution issues if I am reading it right. I’m gonna skip the section of the whitepaper on multi-debt auctions because it does not exist yet.
Pretty typical oracles. Some claim they represent an attack surface and they are right, but not an important one in my underinformed opinion. Some claim they aren’t truly decentralized, and that’s somewhat true, but sometimes you do not have a better option. I have no serious issue with them.
My biggest question here is about how many of these there will be, because this seems like a ton of power. The next section is examples of how to use it and we are gonna skip right over that. Section after that is called addressable market and is marketing bullshit so we are gonna skip that too. Then we get into the risks section and this is where I get excited.
All I have for this part is a reminder that a problem in a DAO smart-contract is the entire reason that Ethereum had to fork. $60 million stolen if I remember right. However, multiple security audits does seem reasonable.
Hey they are aware of my fears, do they have a solid solution though….
Nope….Next risk is competition which I do not care about so skipping.
Yes! We are finally to more of the problems and risks I have been pointing out. Namely they can only increase their liquidity so much to compensate, and they admit right here they need to maintain a large capital pool to feed the bots. You know what that sounds like to me? They’re gonna need more investment continually coming in to keep it working….
Better watch out for the SEC, and the CFTC, and the rest of the alphabet soup….
In conclusion, I still do not believe stablecoins are gonna be effectively created because unless they are backed by the asset they are pegged to and convertible there is always too much risk. This article was written in one night without editing, so please help me out in the comments if you find any errors.