A Cascade of Network Congestion Undermines DeFi’s Potential

Lessons From March 2020’s Financial Crisis

By Yuqing Jiao, Yuanjie Zhang and Eden Dhaliwal

2020 will be a year written into the history books. As the news of the coronavirus started to spread, the collective fear and anxiety started to become more and more apparent. When the stock market in China opened after Lunar New Year on February 3rd, the value of more than 3000 stocks started to drop. By the end of February, new cases of Coronavirus patients were dropping in China, however, in Japan, Korea, Europe and in the United States, the numbers began to noticeably increase. On March 9th, the price of oil began to take a deep dive of 30% and the three major US stock indices dropped sharply right. Dow Jones index fell to 1800 points, while S&P 500 index sank 7%, triggering the circuit breaker (automatic regulatory measures to temporarily halt in trading on an exchange) suspending all trading. This was the largest one-day drop since 2008 and the second time the circuit breaker triggered since 1997. Other global stock markets in England, France, Germany, and Italy also plummeted into a downwards spiral. And the days following on March 12th and 16th, Dow Jones, Nasdaq and S&P 500 continued to fall and trigger circuit breaks again.

Bitcoin Mining Shutdowns

The halving of bitcoin is expected on May 25th and the cryptocurrency market has been eagerly awaiting this day with mixed sentiments of cautious optimism and grandiose predictions of Bitcoin price hitting $100k USD. Irrespective of the builtin scarcity event, Bitcoin has long been argued as a store of value and a safe haven asset, similar to gold. Through this month’s financial turmoil we expected to see rising prices, but instead we say significant price drops from a cascade effect of network congestion.

From March 12th to March 13th, the Bitcoin price fell almost 50%, with lowest prices around $3800 USD. This represents a loss of nearly $60B USD in asset value, marking it the largest one-day drop of Bitcoin history in 6 years. Across the world, more than 100k cryptoasset holders had their portfolio wiped out, with an estimated total value of $3.39B USD. In this unprecedented situation, one aspect in maintaining the stability of a blockchain system has drawn the attention of the community: the survival of the mining machines. On March 13th, mining pool F2Pool published a snapshot of mining-machine shutdown prices (whether a mining machine should shut down when the price of Bitcoin drops below a certain value due to the lack of profitability). As seen in the figure below, more than 10 mining machines should shut down, including Whatsminer M3, Avalon A741, EBit E9+, Antminer T9+, and even the mainstream mining machine Antminer A9. At the time this was captured, an estimated 220,000 operating mining machines were to shut down according to the mining machine shutdown price.

Mining Machine Shutdown Price

As cryptoassets were taking its beatdown, much of the market was desperately trying to sell. However, many centralized exchanges experienced downtimes and maintenance work, thus, restricting the withdrawal of ERC-20 tokens stored on centralized exchanges. As a result of these withdrawal restrictions, assets stored on the centralized exchanges were not able to liquidate and even OTC trading was temporarily discontinued.

Many blockchain communities were frustrated by this, however, they were powerless against so-called “system maintenance” of these centralized systems.

Ethereum Network Congestion

Once Bitcoin tipped over, other mainstream cryptonetworks like Ethereum and EOS started to tip as well. Within two days, the price of ETH fell from $250 USD to $87 USD at its lowest (a decrease of 65.2%), while EOS’ decreased by 53.18%. At this point, Ethereum, where most DeFi projects reside, was next to be exposed with bottlenecked congestion.

Every transaction on the Ethereum blockchain requires a gas fee to be executed by the network, miners decide on the value of gas fee whether or not to put a transaction into a block for execution. The higher the gas fee, the higher the priority of a transaction to be processed by the miners. When large amounts of transactions appear in the network, transactions with low gas fees will be queued and left aside, influencing the normality of transaction processing and congesting the Ethereum network.

On March 12th, the transaction fees on the Ethereum network increased by 10x due to the large number of transfers, rebuys, and withdrawals, escalating the gas fee to 1 ETH just to process a single transaction. On the same day, the total amount of transaction fees paid to the Ethereum network reached $564k USD, almost double the total amount of transaction fees paid to the Bitcoin network of $298k USD. A day later on March 13th, someone paid an astonishing 656 ETH as a transaction fee for a single transaction as seen in the figure below:

Transaction Hash: 0x5f86480294076256406755e62bf7d02a43f3b03579fe4a22f46fc3004428b1ee

Meanwhile, stablecoins were gaining market share during this period. The appeal of low volatility assets tends to supersede the appeal of futures hedging, arbitrage, mortgage replenishment, etc. With everyone trying to withdraw their volatile assets, stablecoins like USDT, have increased in demand and are becoming more scarce, as a store of value, potential medium of exchange and hedging instrument.

DAI, which uses cryptoassets as collateral, has also become more in-demand because of its stable value. While traditional stock markets have a circuit breaker, the crypto world and DAI does not. Because its underlying collateral are volatile cryptocurrencies, DAI has experienced a downward spiral and a large amount of DAI are now under-collateralized. The high demand and under-collateralization could lead to skyrocketing DAI and dissolve its value proposition as a reliable stablecoin.

Another inevitable question is the bottleneck problem of decentralized networks with low throughout and high transaction fees, as an economic crisis will occur again. It doesn’t matter when a crisis occurs, it’s more important to be ready for it.

Suboptimal Networks Undermine DeFi Markets

As everyone knows, Bitcoin emerged as a response to the 2008 financial crisis and initiated a new world of open networks and decentralized finance, most of which on Ethereum. More than ten years later and facing a new financial crisis, we are still struggling to utilize decentralization to volatility in our financial systems, making DeFi an unstable landscape.

Public blockchains are the foundational technology layer to decentralized finance and DeFi products are simply composable building blocks on that layer. No matter how big and novel these building blocks are, they start to collapse when weaknesses of its foundational layer become exposed.

The future lock-up value of the DeFi market has fallen back to its starting value overnight, despite the expectations of a thriving market and promising developments. According to Debank, on March 12, the total amount of DeFi locked positions fell to $660M USD for a short period of time, which translates into a 46% decrease from its peak in 2020. The total amount of DeFi liquidation exceeded $23M USD, which was a 15X increase of the previous day and can be seen in the figure below. The congestion of the Ethereum network has also contributed to the overall liquidation in the entire DeFi market.

MakerDao, which dominates the DeFi space, has shown susceptibility during the recent crisis as well. On March 13th, MakerDao liquidated more than 10 million USD. Maker’s liquidation process is carried out in the form of collateral auctions, and the downturn in market conditions has led to little advantages among the liquidators during the auction period. Some liquidators have raised the gas fee and auctioned up to more than $8M USD worth of ETH collateral for nothing, this has directly resulted in more than 4.5 million DAI being under-collateralized.

On the evening of March12th, the Ethereum network was congested for 4 hours and the auction was closed with $0 USD as a bid from one keeper after no one else bid on it for 3 hours. The figure below shows the bid history:

MakerDao had to go into self-rescue mode since there were over 4M DAI under-collateralized. This meant substantially lowering DAI’s annual interest rate from 8% to 4%. On March 16th, the Maker Foundation further reduced the DAI’s stable fee rate to 0.5% based on the community vote and planned to auction minted MKR on March 19th to pay off the debt.

Most DeFi lending relies on over-collateralization and as large numbers of loans fall below the collateral threshold, more and more accounts trigger automatic liquidation. Most DeFi products with a small pool of funds have experienced a liquidity crisis during this period. Users’ deposits had been lent out, and the borrowing accounts had not been liquidated in a timely manner. Deposit users couldn’t withdraw and after two days of the bloodbath, the amount of deposits and loans in the DeFi market had also been greatly reduced.

Interest on Deposits

Interest on Lending

If a transaction cannot be processed on Ethereum and lenders cannot replenish their collateral in time by depositing more digital assets, they can only stand and watch while their account is being liquidated. Furthermore, when a large amount of oracle price feeds are not updated frequently enough, traders cannot place pending orders at the actual market price. On the night of the plunge, the price of MakerDao oracle was hovering for a while. Unfortunately, some assets were liquidated because of the inability to deposit more ETH in the collateral vault in time. Essentially MKR holders had two years worth of earnings wiped in less than 24 hours.

Source: Spencer Noon Newsletter ‘Our Network’

Decentralized exchanges are doing reasonably well during these rough days. According to statistics, on the evening of March 12th, the trading volume of the decentralized exchange exceeded $100M USD. Some cryptocurrency users were able to escape Black Thursday through decentralized exchanges, but due to the high transaction fees of the Ethereum network, a big portion of their assets was sadly taken during the escape.

Taking Open Finance To The Next Level

During this month’s financial distress, the market sought to answer many key questions about the nature of cryptoassets. Are cryptoassets correlated to the capital markets? Is Bitcoin a safe haven asset? Is it even a store of value? If we were able to relieve network congestion, then we’d be able to relieve the negative domino effects that we witnessed. It’s also possible we could have seen a quick and positive bounce back from the crypto markets. The current conclusions about correlation, safe haven characteristics and store of value are incomplete until we solve for scalability.

The recent market downfalls also signified that the performance of the underlying infrastructure is now more important than ever. This is not the first time that Ethereum has experienced massive network congestion. When CryptoKitties was launched in January 2018, a ton of people were compelled to use the app, causing the first network congestion of Ethereum, which led to a peak transaction fee of $0.02 USD back then. When Fomo 3D game was launched on July 18th, the number of confirmed transactions on Ethereum exceeded 70,000, and caused another network blockage. Until recently, the topic of TPS and cases of network congestion have been relatively ignored and without significant consequences.

The 2008 financial crisis brought economic loss on a global scale of trillions of dollars, while the recent losses due to blockchain network congestion in 2020 was roughly only $16M USD. Compared to the traditional capital markets, the asset volumes on Ethereum are insignificant. However, it’s clear that the Ethereum network recently failed the stress test of a significant market shift from a small-scale financial market. Many developers are collectively calling for ETH 2.0 Phase 0 to come soon and it may very well arrive in April. We’ll start to get some indication of whether Phase 0 can deliver a high performing public infrastructure under POS consensus without losing security.

As stated previously, the data shows that Ethereum had nearly 80K transactions that were in congestion due to poor performance, with an average on-chain time of 4 hours. MakerDao’s massive collateral auction could not be processed on-chain within 3 hours, causing the earliest keeper to bid 0 DAI and obtain collaterals worth $4M USD at zero cost. If MakerDao was running on the Conflux Network, with a processing speed over 3,000 transactions per second and on-chain settlements within seconds, the stalled 80,000 transactions would be run smoothly on-chain within a minute.

Conflux is committed to providing the most advanced technical support to make decentralized finance successful, especially in times of crisis. On the Conflux network, transaction fees will be reduced significantly. Developers on Conflux can opt to pay the transaction fees of the users and lower transaction costs. Conflux’ TPS speed is currently unmatched and can now create on-chain blocks within seconds with block confirmations within minutes. These performance breakthroughs eliminate the essence of network congestion, making decentralized user experiences comparable to existing centralized user experiences. Once we reach this level of seamlessness, we will resolve the negative cascade effect from centralized mining pools, exchanges and lending services and provide a stronger foundation for the composable building block of decentralized financial applications.

What’s Next For Conflux Network?

Together with our ecosystem partners, Conflux Network will continue to actively host AMAs, publish new insights and educate on decentralization, in order to further our mission of bringing open commerce to the world. Conflux Network has been working with a number of DeFi platforms like Dforce, Chainlink, etc to construct a vibrant decentralized ecosystem.

Conflux network is compatible with Ethereum EVM, which is convenient for Ethereum developers to carry out effortless migration. At the same time, Conflux’s smart contract design has made some key innovations allowing developers to pay for the user’s transaction fees and let others sponsor the developer transaction fees. Developers can apply to participate in the Conflux Ecosystem Development Program, which the Conflux Foundation will fully subsidize the transaction fees of on-chain transactions executed through smart contracts, zeroing the fees of some users and developers.

The Conflux Foundation will provide capital to DeFi projects building and growing on the Conflux network. In fact, Conflux has already funded $500K USD and $100K USD in lending platforms Lendf.me, and DDEX respectively. With the launch of the Conflux Blockchain Research Institute in Shanghai, Conflux Network will incubate decentralized startup projects, provide office space, and support them with regulation, funding, and technology.

“Today is cruel, tomorrow is also cruel, but the day after tomorrow is beautiful”

Jack Ma, Founder, Alibaba

The unexpected downturn in the markets provided us some important insights into the network deficiencies that affect the crypto markets and DeFi ecosystem. It should provide the entire blockchain and DeFI community more motivation in building towards a better future. We’re confident that the Conflux Network will provide critical public infrastructure for many of the solutions that are required today.

Special thanks to Christian Oertel for his work as editor and translator for the Conflux Network blog