Review Mirror Protocol — One DeFi Protocol to Mirror Them All
Executive Summary
Mirror Protocol has been the first DeFi protocol released on the Terra blockchain and presumably kickstarted the current high growth of the Terra ecosystem as well as increasingly high demand for the native USD-pegged Terra-stablecoin UST.
Mirror allows everyone to create and trade synthetic assets — so-called Mirror Assets (mAssets), which track the price of specific real-world assets like stocks or ETFs— across Terra, Ethereum, and Binance Smart Chain.
The protocol — as well as its native governance token $MIR — has seen constant growth since its inception in December 2020, which is reflected in $2.3 billion TVL, a constantly high trading volume, and a market capitalization of $0.5 billion for $MIR. Version 2 of the protocol, which adds valuable improvements and fixes to the protocol, is expected to be released in May 2021.
Introduction
The current macroeconomic situation has led to a deterioration of interest rates in the financial markets for both institutions and retail. This development was driven by the major economic crisis in the last decades (the burst of the dot-com bubble in 2000, the near-collapse of the financial markets in 2007–2008, and omnipresent market turmoil driven by the Covid-19 crisis in 2020 and 2021) and the monetary and fiscal politics in reaction to these.
Lower interest rates have been the result which again led to lower bond yields and consequently lower yields on other assets. A drastic change in this situation and significantly higher yields are not foreseeable right now because an increase in interest rates through central banks is unlikely in the coming years as this would put pressure on liquidity in an economy that has been hurt worldwide due to the effects of the Covid-19 pandemic.
These events have triggered a “search for yield”, wherein the wake of a fall in bond yields other asset classes become more attractive to investors, driving up prices of equities, commodities, and cryptocurrencies like Bitcoin and Ether.
The US economy has traditionally been a magnet for all kinds of foreign investment and has seen massive inflows in trillions of dollars in the last years. The FDI (Foreign Direct Investments) of the US is higher than any other country in the world. On the other hand, we are experiencing another retail mania in the stock markets enabled by e-brokers such as Robinhood and others that allow Americans to buy and sell stocks from their smartphone. Individual stocks and ETFs are two investment vehicles that benefit from both of these trends.
The Rise of DeFi
In the aftermath of the global financial crisis in 2007 and 2008, we have witnessed the rise of cryptocurrencies with the launch of Bitcoin in 2009, Ethereum in 2015, and thousands of other projects until today. This has then led to the rise of Decentralised Finance (DeFi), which tries to offer a fully transparent and open alternative to the existing traditional financial ecosystem built on top of blockchain technology that does not rely on central intermediaries.
The DeFi ecosystem has re-built many traditional financial instruments such as borrowing & lending, decentralized exchanges, derivatives as well as hedge funds and has attracted more than $50B by April 2021. Since its first bloom in the “DeFi summer” of 2020, participants can earn a high yield of 20% and more (up to several hundreds of percent) on their capital based on current high borrowing demand, an early distribution of protocol tokens, and fee accrual towards protocol “shareholders”, often relying on some kind of leverage. By April 2021, the continued DeFi boom has led to the combined value of all DeFi tokens to close to $150B.
The Problems Mirror Is Trying to Solve
Right now, investing in US assets like stocks and ETFs is restricted and requires dealing with several centralized institutions.
Large parts of global society are unable to access these investment opportunities because they are unbanked, are unable to pass KYC, or live in a country with restricted access to the financial markets.
Also, cases like Robinhood’s blocking of Gamestop stocks and the firm’s alleged selling of user data to BlackRock (you can read more about it here https://www.jacobinmag.com/2021/02/gamestop-stock-market-reddit-robinhood) shows that even “disrupting FinTechs” that claim to “democratize trading” are on the leash of Wall Street.
Decentralized Finance (DeFi) is the antithesis to this and strives for global access to decentralized and transparent financial opportunities governed by the community itself. Mirror Protocol follows this vision and allows everyone to get on-chain price exposure to US stocks and ETFs based on synthetic assets that live on the Terra blockchain.
Also, restricted opening times, weekends, and public holidays have no negative impact on decentralized trading on the blockchain as it allows for 24/7 trading of any digital asset without counterparty risk.
The Foundation: The Terra Blockchain
Anchor Protocol is built on top of the Terra blockchain, which itself is Cosmos-based and has been launched in 2018 by Terraform Labs based in South Korea. Terra offers a highly scalable blockchain with native stable coin support that allows for programmable money and an open, decentralized financial infrastructure built on top of it. It supports a basket of fiat-pegged, seigniorage share-style stablecoins which are algorithmically stabilized by the native crypto asset, Luna.
Terra’s stablecoins rely on a dual token system involving its native LUNA token.
The initial usage for Terra came from the highly popular payment app Chai in South Korea that utilizes Terra’s KRT stable coin (pegged to KRW) and allows for immediate settlement between buyer and seller. Chai now has more than 2 million users and catapulted Terra into the top 5 blockchains based on generated fees. The launch of the synthetic asset protocol Mirror Finance and Anchor Protocol led to a surge in UST (Terra’s native USD-pegged stable coin) demand, which is now a top 5 stable coin in terms of market capitalization.
At this point in time, many different projects are built on top of Terra, not only from the official Terraform labs team but from many different participants around the world. This additional growth was partly driven by newly launched Terraform Capital, Terra’s own venture fund providing free access to launch capital for new networks and projects.
The Team Behind Mirror
Mirror Protocol has been developed by Terraform Labs, the company behind the Terra Blockchain, which has been founded by its CEO, Do Kwon. Do Kwon has been in the Forbes 30 under 30 Asia list (you can find his profile here) and started Anyfi, a wireless mesh network startup, before transitioning into crypto finance.
The team responsible for Mirror Protocol is not publicly known, and the Mirror Protocol whitepaper has no listed author.
How Mirror Protocol Works
Mirror Protocol allows the issuance (minting) and trading of synthetic assets (which are fungible assets) based on oracle price feeds. At the point of writing, Mirror Protocol supports 23 synthetic assets across three categories: US stocks, ETFs (or Trusts) & Cryptocurrencies. Examples are mTWTR (Twitter), mNFLX (Netflix), mAAPL (Apple), mIAU (iShares Gold Trust), and mBTC (Bitcoin).
These synths are also called “mAssets” (Mirror Asset) and are intended to be used as key building blocks in smart contracts to allow composability and are not only available (and therefore tradable) on the Terra blockchain but also on Ethereum as well as Binance Smart Chain (BSC) and in the future also potentially on other blockchains.
The system is collateralized by the Terra-native stablecoin UST, a USD-pegged algorithmic stablecoin. The advantage of stable collateral is a lower collateralization rate (150%) compared to systems where a volatile digital asset is used as collateral (e.g., Synethix on Ethereum where $SNX is used as collateral, requiring a collateralization ratio of 600%).
mAssets do not share a single liquidity pool but have their own distinct liquidity pools based on a CFMM (Constant-Function Automated Market Maker) model, which is very similar to a typical “x × y = k” AMM (e.g., Uniswap, Sushiswap, Bancor) which means each pool consists of 50% UST and 50% the respective mAsset.
Liquidity providers are currently incentivized by the issuance of $MIR, the native government token on Mirror Protocol.
Minting and Burning of mAssets
In order to mine mAssets, you must lock up at least 150% of the current asset value in UST or another mAssets as collateral (in the case of the latter, a collateralization ratio of 200% is needed). If the value of the asset rises above the collateralization threshold, the collateral is liquidated to guarantee the solvency of the system. This means you create a collateralized debt position (CDP), essentially equaling a short position against the price movement of the reflected asset, because if the value of the mAsset rises, you need to put up more collateral to maintain the required collateral ratio. For riskier or more volatile mAssets, it is recommended to go beyond the minimum collateral ratio and add at least a safety buffer of another 50%. Additionally, regular monitoring of one’s position and the collateral ratio is recommended to avoid a margin call or liquidation.
To retrieve your collateral, you need to “burn” the equal amount of mAssets that have been issued at the opening of the CDP.
The community itself decides via governance votes which new synthetic assets should be added to the protocol. Since its launch, this has led to the addition of mCOIN (Coinbase), mDOGE (Dogecoin), mGME (Gamestop), and many other assets.
Oracle Price Feeds
To retrieve the correct price of a mAsset, Mirror Protocol has partnered with the oracle provider Band Protocol. Band Protocol delivers a decentralized price feed for every synthetic asset that is refreshed every few seconds. When the price of the mAsset drifts significantly from the primary market, traders are incentivized to purchase (or sell) the asset to mint (or burn) to claim the collateral.
Trading of mAssets
mAssets can not only be traded on Mirror Protocol’s own web app and Terra’s own DEX Terraswap but also own a dedicated native mobile app called “Mirror Wallet” and thanks to a bridge to Ethereum and Binance Smart Chain also on those two blockchains.
As mAssets need their distinct liquidity pools, Mirror Protocol has created a separate staking app (fed by Uniswap liquidity position tokens) on Ethereum (https://eth.mirror.finance/) and partnered with Pancake Swap on BSC.
Mirror Wallet
Mirror Wallet is a non-custodial wallet independently created and maintained by ATQ Capital (independently from Terraform Labs). Users can fund their wallet with cryptocurrencies or stablecoins like Bitcoin and Tether and offers a FIAT on-ramp integration with Moonpay.
Right now, buying mAssets comes with a premium between 5% and 10% compared to the underlying price feed (which is also used to define the value for minting). This is one issue that the team wants to address with V2 of the protocol, which can be expected in May 2021.
The First Months of Mirror Protocol
Mirror Protocol was launched in December 2020 as one of the first major DeFi applications on top of the Terra blockchain. Terra has been relatively unknown back then in the crypto world, but despite that, Mirror has gained quite a lot of attention because of its great usability, ease of use, low fees, and high transaction speed. Also, the Gamestop rally has played into the hands of Mirror, as the many downsides of centralized stock trading apps like Robinhood suddenly became obvious.
Until today, Mirror has attracted $2.3 billion in total value locked (TVL), nearly $0.5 billion in mAssets market cap, and an average daily trading volume of $40M.
During the first months, the protocol has added several new synthetic assets based on community votes and allocated some community funds towards community initiatives and development projects which shows that decentralization already works quite well despite the nascent stage of the project itself.
A Comparison with Synthethix
Ethereum-based derivatives protocol Synthetix (https://synthetix.io/) is not only one of the most widely known DeFi protocols and “father” of the idea to bootstrap adoption through the distribution of governance token (in this case $SNX) but also a logical competitor of Mirror Protocol.
Synthetix was also the first DeFi protocol that introduced synthetic assets allowing investors and traders to mint or trade derivatives of real-world assets or cryptocurrencies. Mirror shares several key mechanics with Synthetix but differentiates itself in some important details. For example, Synthetix used its native token $SNX as collateral which is highly volatile and therefore requires much higher collateralization than Mirror, which uses a stablecoin as collateral (UST). On the other side, there is one shared liquidity pool for all synthetic assets on Synthetix compared to individual liquidity pools on Mirror.
The following table contains some major differences between the two protocols, also in terms of valuation.
Risks
Mirror Protocol shares many of the risks of all other DeFi protocols but also some additional ones specific to protocols utilizing stablecoins and collateralized debt positions. This is not necessarily a complete list of all risks, so please always do your own research before using this or any other DeFi protocol.
- Smart contract risk: Errors or exploits leading to a loss of funds because of protocol errors or malicious actors.
- Layered risk: The composability in DeFi could lead to a multiplication of risks as several protocols work together or are built on top of each other. Therefore a bad event in one of those could lead to a negative chain reaction and affect all other protocols too.
- Other software risks: Malicious attacks such as hacks, DDoS attacks, or similar could lead to the temporary unavailability of the service or even data loss.
- Market risk: A black swan event could lead to either a massive price fall for LUNA (leading to mass-liquidations as the value of the provided collateral goes down too) or MIR. Also, UST could lose its peg, leading to unforeseen consequences to the whole Terra ecosystem. This again could lead to a liquidity crisis based on a “bank run” as participants want to retrieve their funds.
- Liquidation risk: If the value of one’s collateral falls below a certain threshold compared to one’s debt (collateral ratio), the collateral will be fully or partly (depending on the total value) liquidated to ensure stability and collateralization of the protocol. Therefore the collateral ratio should always be monitored.
- Economic incentive risk: Network participants could be encouraged to act in bad favor or against the design of the protocol. Also, liquidity could flow out of the protocol once incentives stop.
- Regulatory risk: New country-specific regulations could affect the protocol in negative ways, e.g., restrict its usage of Mirror’s mAssets or Terra’s algorithmic stablecoins (UST).
Upcoming improvements with Version 2
Mirror Protocol V1 launched in December 2020 and already has Version 2 lined up to be launched in May 2021 to both improve and expand the protocol’s functionality. The original forum announcement can be found here (https://forum.mirror.finance/t/mirror-v2-updates/1077) but let us quickly summarize the planned enhancements:
Introduction of Pre-IPO Assets
Version 2 of Mirror will allow to mint and trade pre-IPO assets (the value of company shares before they have officially completed their IPO) after an SEC Form S-1 and an initial price estimate has been published.
Improved governance participation incentivization
Governance has been an issue with Mirror, as many pools have not passed the quorum despite a high number of $MIR staked in governance. In V2, users who actively vote in polls will receive a greater share of $MIR issued to governance.
Additionally, the current problem that polls often sway between hitting the 10% quorum and dropping down to 9.99% due to more $MIR being staked in governance will be solved.
Additional collateral
MIR, LUNA, ANC, bLUNA, aUST will be allowed as collateral Mirror on top of UST.
New minting process
The above-mentioned problem of price premiums compared to the oracle price (partly due to high demand for staking and buying despite the premium being more capital efficient than minting) will be remedied by an altered minting and inflationary reward distribution structure and the automatic creation of non-tradable ‘short’ LP tokens during the mint.
Change to Uniswap MIR incentives on Ethereum
The current $MIR incentives for Uniswap LP positions for mAssets will be moved to the community pool to allow a new proposal as the trade volume has been relatively low on Uniswap.
Chainlink as second oracle provider
Chainlink will be added as a second oracle provider to Mirror Protocol in addition to Band Protocol.
The $MIR Token
Mirror Protocol features its native governance token $MIR, which serves to facilitate decentralized governance through the community as well as to bootstrap liquidity through incentives and comes with a deterministic inflation schedule.
The following table shows the initial $MIR token allocation plan. Please be aware that some changes to this will be introduced with the launch of V2, such as the migration of Uniswap mAsset LP rewards.
As you can see, $MIR is facing a high inflation curve during the first years, as 75% of all $MIR tokens of the first year’s supply are distributed to liquidity providers and LUNA stakers during the first 12 months. This inflationary pressure is one potential reason for the slow growth of the market cap of $MIR after the initial steep ascent to the current ATH of $12, which was achieved in April 2021.
Beyond year 1, LP rewards will continue for an additional 3 years through inflation but at a rate of 50% of the previous year. Also, the Community Development Fund will be replenished for an additional 3 years through inflation. The rate of growth will be 10%, 20%, and 20% of the Year 1 Supply in years 2, 3, and 4, respectively. (Source: Arrington XRP Capital)
Inflation will after year one significantly, but this also poses a risk to the functionality of the protocol as incentives for liquidity providers will be reduced.
MIR Price Performance
The $MIR token has remained relatively stable during the first weeks after launch and only started its ascent to ATH in February 2021 at about the time when the protocol has received increased media coverage because of the Gamestop incident. The current ATH of $12 per $MIR token has been reached in April 2021, followed by a correction to the support level of about $7.5.
Farming Opportunities on Mirror
Mirror introduced some very lucrative farming opportunities on top of the Terra blockchain as well as on Ethereum and Binance Smart Chain.
Mirror Protocol itself has allocated a significant portion of the $MIR inflation towards liquidity providers for both $MIR trading pairs and all mAssets. At the point of writing, providing liquidity is rewarded with between 45% and 110% APR, respectively (200% to 60% APY when compounded daily). The difference in APR and APY is especially important for users on Terra and BSC as the low fees allow for daily compounding (claim rewards & re-invest).
Mirror also entered a partnership with Pancakeswap for BSC, which means that liquidity pools on Pancakeswap are also incentivized in $CAKE.
For a detailed guide on how to provide liquidity for Mirror Protocol on Terra, check out my Twitter thread:
For all of these farming opportunities, entering an AMM-based liquidity pool with an equal allocation of two assets is required. If you are new to providing liquidity like this, I recommend reading the following article on this topic:
The Good and the Bad
To conclude this review, let’s summarize the current key strengths and weaknesses of the protocol in a few bullet points:
Strengths:
- Built on a highly scalable blockchain allowing for high transaction speed and low fees
- Steady growth in liquidity and trading volume
- Capital-efficiency based on UST as collateral
- Userfriendly interface & native mobile trading app (Mirror Wallet)
- mAssets trading across Terra, Ethereum, and BSC
- 24/7 trading and minting of stocks & ETFs (based on price exposure)
- Upcoming Version 2 with valuable improvements
Weaknesses:
- Liquidity separated per mAsset with individual AMM-like liquidity pools
- Still relative low awareness of the project across the cryptoverse and public media
- Competitor Synthetix currently ahead in terms of announced features and ecosystem (futures, options, integrations across Ethereum, etc.)
- High token inflation during the first 12 months
- Governance participation not incentivized well enough to foster active participation (addressed through V2)
- mAssets trading for a substantial premium compared to oracle price (addressed through V2)
The Future of Mirror
Mirror Protocol is still early. The world has yet to understand and embrace DeFi and its core principles, and many are already struggling to use the easiest concepts in decentralized finance like borrowing and lending. Mirror is one step ahead and allowing everyone to create and trade derivates 24/7 independently where they are.
But being early is not a guarantee of being successful — many ambitious projects were actually too early.
I currently see three major success criteria regarding a positive future of Mirror:
- Are mAssets are actively used across multiple blockchains as money legos?
We already see this with Synthetix on Ethereum, where multiple independent protocols use synthetic assets for their own value proposition (e.g., Kwenta for trading, Lyra for options, dHedge for portfolio management, Curve for swaps). Regarding Mirror, SparProtocol is the first known project that will use mAssets for their social investment platform (similar to dHedge).
2. Is there real demand for decentralized derivatives/synths?
Applications like Alice or Mirror Wallet try to reduce the complexity of DeFi and bring mAssets (and other Terra-based products) to the smartphones of retail investors worldwide. But will there be a real lasting demand to get exposure to decentralized synths (that do not offer real equity and, therefore also no dividends)? Many are convinced of this, which led to derivatives being one of the hottest future topics in DeFi, but only time will tell.
3. Will there be sufficient liquidity for mAssets across multiple blockchains?
Mirror is more capital efficient than Synthetix but is limited in terms of liquidity as it uses individual liquidity pools per mAsset being dependent on the community to distribute capital accordingly based on an incentive scheme. Only a limited set of the most used mAssets might get enough liquidity to be actually used (short tail), but what will happen then to the long tail and the opportunity to potentially provide price feed for every asset on the planet?
Important Links:
Mirror Protocol: https://mirror.finance/
Mirror Protocol Documentation: https://docs.mirror.finance/
Mirror Whitepaper: https://docsend.com/view/kcsm42mqiyu5t6ej
Mirror Community Forum: https://forum.mirror.finance/
Mirror Market Dashboard: https://mirrormarket.finance/
Mirror Wallet: https://mirrorwallet.com/
About Qi Capital
Qi Capital is a group of like-minded and experienced individuals from around the globe, sharing two common objectives: providing insights about crypto and DeFi, and proactively working with ambitious teams on the future of decentralized finance. Our core principle is to promote and foster individual creativity, growing not only as a group but also as creative thinkers and builders. To learn more about us, check out our website www.qicapital.org and our “Qi Podcast” via www.buzzsprout.com/1729379/ or engage with us on Twitter: @QiCapital.
Disclaimer
Some members of Qi Capital own or farm MIR, LUNA, and other Terra-related digital assets. This statement is intended to disclose any conflict of interest and should not be misconstrued as a recommendation to purchase any token or participate in any farms. This content is for informational purposes only, and you should not make decisions based solely on it. This is not investment advice. All market prices, data, and other information are not warranted as to completeness or accuracy, are based upon selected public market data, and reflect prevailing conditions and the author’s own views as of this date, all of which are accordingly subject to change without notice.
