Stablecoins 2.0: Economic Foundations for DeFi
By: Ariah Klages-Mundt
Tags: Compound Finance, Decentralized Exchange, Decentralized Finance, Cryptocurrency, Stablecoin Cryptocurrency

The news of the week is Compound’s COMP token distribution, which has turned into a circus of leveraged risk with users jumping through crazy hoops of leverage to try to game the reward mechanics.

Navigating yield farming on Compound right now

You can watch live on Ethereum while traders farm COMP profits by balancing complex layers of positions: e.g., deposit ETH and USDC, borrow a high amount of BAT, re-deposit that BAT in a new Compound account, then borrow ZRX against that BAT and re-deposit in the initial account, and then borrow more BAT against the ZRX, etc. If you’re not doing this and think “wish I’d thought of that”, we feel obligated to stress: the risks in those layers of leverage, especially in thin markets like BAT and ZRX, are worthy of their own post (but briefly recall cascading liquidations on Black Thursday and the fact that thin markets are easily manipulated, opening an attack vector to trigger and profit from such liquidations).

If aiming to optimize the spectacle, then the COMP distribution is undeniably a wild success. More prosaically, it addresses the chicken/egg problem of platform usage by temporarily boosting liquidity returns. More cynically, it sets the platform up for a massive exercise in stress testing.

Less discussed, is the initial aim: to foster “an increasingly large ecosystem […] will be incentivized to collectively steward the protocol into the future with good governance”. In essence, the token distribution tries to achieve wider governance distribution among users of the platform, who can steward their own security. We provide a new perspective on this point based on a framework of incentive security in our new paper.

Incentive alignment is a wider issue across crypto-economic systems. We develop a framework for quantifying this issue in the context of stablecoins, though it is widely applicable to crypto-economic systems. We propose a fundamental question of incentive security in a system:

[Incentive Security] Is there mutually profitable continued participation across all required parties, after accounting for attack surfaces?

If not, then the system cannot work as equilibrium participation is zero. For instance, if incentives lead to profitable attacks, then rational agents will price in this risk in deciding a level of participation. Only after this question is answered can we then make sense of the question of economic stability:

[Economic Stability] Do the incentives actually lead to stable outcomes?

Incentive sustainability, or impossibility?

From the models we construct in the paper, sustaining incentive security against governance attacks becomes a critical issue as the system scales. A governance attack is profitable if the rewards from the attack outweigh the costs of that attack. The rewards are proportional to asset value locked in the system (AUM): governance with very broad powers could directly steal collateral (as well as emptying related liquidity pools on DEXs); governance with less broad power may still do so indirectly by manipulating parameters and coordinating the prevention of exits, even under governance time delays. The costs include the governance token value, which has a fundamental value for ‘honest’ governors (i.e., who don’t attack) based on future fee accrual to governance, and any institutional liability (e.g., legal recourse).

Stablecoins, synthetic assets, cross-chain assets

For non-custodial stablecoins (as well as synthetic assets and cross-chain assets from BTC, which use similar mechanisms), a secure governance value needs to be some multiple of locked assets. The scaling issue manifests when considering a long-term equilibrium with moderate future growth expectations, in which case discounted future fees (even if an unrealistically high percentage of AUM) won’t reasonably reach the level of multiples of AUM. In that case, the security of a decentralized governance system will rely on system participants holding governance tokens to big up governance market value. This will feedback into participation incentives of these other parties; there is no guarantee that equilibrium participation exists. To illustrate, stablecoin holders may need to hold significant positions in a risky governance asset in order to secure their stable positions, which may defeat their purpose in holding the stablecoin. This leads us to an informal impossibility conjecture (and an important direction for future research!):

[Conjecture] In many DeFi systems designed with broad governance powers and without societal recourse, equilibrium participation of rational agents may be zero.

In essence, the cost to participants to align incentives in these systems may be prohibitively high. A concrete analogy is a bank: if incentive security requires the bank’s equity market value to be worth multiples of total deposits, then it simply won’t be worth it for depositors to participate. Put another way, the bank’s long-run P/E ratio would need to be ~1000 (and propped up by depositors) to secure the bank from the theft of depositor funds.

Currently implemented solutions essentially centralize governance. This solution relies on a form of institutional liability, representable within our models. This is not necessarily a problem. Indeed, many traditional financial systems operate in this way. This is why banks do not need to be worth multiples of total deposits. However, we should openly recognize that this trust line exists and may be vital. Solving these problems in a fully decentralized way remains an open problem.

Decentralized Exchanges (DEXs)

These incentive models are also relevant for some DEXs. For instance, when a DEX operates its own (governance controlled) chain, governors have the ability to restrict the exit of liquidity participants under an attack, even under governance delays. In DEXs, fee accrual (‘honest’ governance profitability) is proportional to a fraction of total volume over time, which can be many times the value of the instantaneous AUM on the exchange, while incentive security is still related to AUM. A key modeling component will be a behavioral factor of volume relative to deposits. For Uniswap,annualized volume can be ~100x deposits. In comparison, a collateralized stablecoin accrues fees on borrowed assets, which can be ~1/4 of supply deposits. While equilibrium fees accruing to governance may be much small in DEXs than stablecoins, this ~400x factor makes the feasible region for incentive security against governance attacks potentially larger in DEXs. This leads us to the following informal conjecture, comparing feasibility of different types of DeFi applications:

[Conjecture] It is fundamentally easier to economically secure DEXs against governance attacks than stablecoins.

These possibilities reinforce the importance of studying mutual incentives in choosing the right DeFi design for a given application, as well as the problems that yet need solving (DeFi researchers take note).

Lending Protocols

In light of this discussion, we return to the initial consideration of collateralized lending protocols, like Compound. These share a similar structure to non-custodial stablecoins. They’re slightly simpler, however, in that borrowed assets are largely exogenous. As a result of this exogeneity, participants may more readily exit the system before a governance attack is realized (i.e., during the governance time delay). For example, consider that the borrowed asset is USDC; in this case, a vault can always create new stablecoins at par through the issuer to deleverage and exit (in particular, they don’t rely on Dai holders selling them back Dai when they want to exit). In essence, governance time delays are a more powerful preventive tool in this setting — with a likely exception of more complex price feed and/or miner extractable value attacks.

This said, some of the smaller cap assets in Compound may start to diverge from the exogenous case. BAT and ZRX markets are largely over-utilized as they are currently favored for yield farming. For instance, BAT utilization is currently 91%, and the current notional value of BAT deposited is $234m, whereas the total market cap of BAT is $377m (though some amount of this BAT would net out as it comes from layers of borrowing and re-depositing the same initially deposited BAT). In light of this structure, a large unwinding of BAT positions could see similar deleveraging effects to stablecoins, as discussed further below.

Compound stats on 23 June 2020.

A remaining question is: does the COMP distribution process help to increase long-term incentive alignment? That is, does it help to decrease the costs to users to secure the system against governance attacks? At first glance, this looks promising. Users are awarded governance shares through participating and so don’t have to consciously bid up the governance market value to secure the system — they just need to not sell the shares they are awarded. This last point illustrates the lack of guarantee here: once users are gifted the shares, it is a part of their portfolio, and they choose whether to maintain that risky position. While the COMP distribution no doubt draws lots of new users into Compound today, it’s still an open question whether the COMP distribution mechanism (or indeed any other distribution mechanism) helps to get us to a more stable governance equilibrium.