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When Protocols Collapse — Important Lessons In Risk From DeFi

Iron Finance was an emerging DeFi protocol, until its collapse on June 16, 2021.

POST MORTEM Report:
DeFi Bank Run ….” Perhaps one of the worst crashes in the DeFi space, after the Yam protocol. In their report, posted on Medium, Iron Finance admits the problem:

“We never thought it would happen, but it just did. We just experienced the world’s first large-scale crypto bank run.”

It is definitely not a nice thing to have to say. To even mention “world’s first large-scale crypto bank run” means they are owning it but not proud to say it. Prior to this, the potential for Iron Finance was gaining plenty of attention. One of its supporters was businessman Mark Cuban, so it would seem like there was legitimacy in this project. The pitch for Iron Finance was for massive gains in yield farming.

Yield Farming

One of the main features of DeFi that is attracting capital is in yield farming. Investors can make plenty of money from APY in liquidity pools. Iron Finance issues a stablecoin called IRON, which is backed (not fully) by certain assets (includes other stablecoins like BUSD, USDC, and USDT). It is partially collateralized, so it is not pegged at a 1:1 ratio with another asset. It must be pegged 1:1 to the US dollar (USD). They also issue a token called TITAN, which is used for minting new IRON tokens.

Iron Finance uses the Binance Smart Chain and Polygon blockchain for transactions. As part of these ecosystems, it provides a multi-chain protocol that allows users to earn yields. These are returns for users to become liquidity providers by depositing money in a smart contract for a liquidity pool. A typical return on APY is between 3–10%. Iron Finance, on the other hand, offered yields of more than 1,000% and even higher. That seems like a good investment decision, but unfortunately, the numbers just aren’t sustainable to the reality in the market.

The Tokenomics

Before we get critical of Iron Finance, let’s look at their tokenomics. When putting money on their protocol to earn yields, you can either mint or redeem tokens. When minting IRON tokens, users must deposit into a liquidity pool token pairing that uses TITAN tokens (e.g. TITAN/USDC). The user then gets freshly minted IRON tokens of the valuation based on their deposit. The TITAN/USDC deposit is locked in a smart contract and can now earn from transaction fees from the liquidity pool. This is how users earn from the protocol.

When a user wants to remove liquidity, they can redeem it by selling IRON tokens to get back their locked tokens. That also includes the returns from yield farming. This attracts investors because of returns of 1–5% daily. An investment of just $1000 could earn users $40 a day (depending on the rate for the token pairing in the liquidity pool). The higher your investment, the greater potential profit.

The other catch is that when using Iron Finance’s protocol on DeFi platforms like Polycat, the yields earned can be reinvested. These platforms are auto-compounders, so they can earn more money for users. So far so good, so what are the risks? It is the price of the tokens that any investor should be watching out for. If the valuation of TITAN goes down or IRON loses its peg, it will affect a user’s investments.

A screenshot of the massive potential gains for users using Iron Finance.

The Collapse

Beginning on June 16, the price value of TITAN began to dip. As it dipped, traders began to realize this, and the sell offs began. It would seem normal at first since the cryptocurrency market was at a downtrend of sorts following several weeks since May 21. That was until the imminent collapse. What happened was large holders (aka whales) began to remove liquidity in the IRON/USDC pool. This caused the value of TITAN to decrease, and IRON began losing its pegging to the US dollar. The whales began to sell TITAN for IRON and then IRON for USDC.

The price of TITAN began to drop, from $64.04 to $30 in just 2 hours. IRON also lost its peg to USD and dropped in price from $1.00 to $0.70. If this were a correction, the slide would have ended here, and things would recover. It seemed like that at first since TITAN prices began to increase to $52. It was not yet over.

The large redemptions for newly minted IRON began flooding the market with TITAN tokens. The whales will then sell off their TITAN. With more TITAN tokens being sold on exchanges, the sell pressure leads to a fall in value. Other users and traders see the prices falling, then begin panic selling in anticipation of prices falling even further. That usually becomes a self-fulfilling prophecy because that is how markets tend to behave.

As the price of TITAN continues to fall, IRON cannot maintain its peg to USD. Users now begin minting more IRON to sell off their TITAN tokens since it is losing value. The process of minting and selling leads the prices to fall even further until it hits close to $0 for TITAN, while IRON was worth $0.75. By June 17th, the value of TITAN had fallen by 98.1%. This was catastrophic indeed since it happened rather quickly. Some users lost money without being aware of the problem until the last minute. Others had to accept their losses and just sell to regain some of their investment.

This chart outlines the collapse of TITAN, from $64.04 to close to $0, between June 16–17, 2021. (Source Coingecko)

Synopsis

In the end, it was tragic for all who invested their money and believed in the protocol. While some are calling this a rug pull, it is more likely a flaw in the system design of the protocol. A rug pull would be more of an exit scam by the developers, but that does not seem to be the case. It was most likely a bank run, as mentioned before, which was unexpected.

The big question is, were the developers aware that such bank runs could occur, or were they too confident about their protocol to even care?

According to Iron Finance’s blog post on Medium:

“We must conduct an in-depth analysis of the protocol, for which we will hire a 3rd party, in order to understand all circumstances which led to such an outcome.”

It is not certain if Iron Finance can recover from this. They can definitely improve upon their protocol, like being more realistic with returns to users. Overall, this problem does not affect all DeFi protocols. Other protocols have been successful for liquidity providers and yield farmers without experiencing a bank run.

It turns out that Iron Finance was based on FRAX, which developers forked the code from. FRAX is an algorithmic stablecoin protocol. Unlike Iron Finance, FRAX does have a locking period for tokens which could prevent such problems with simultaneous sell offs. FRAX uses a technique called time-locked staking. With this in place, tokens can be locked up for up to 3 years. That means that whales can only remove their liquidity from a pool after a certain amount of time.

Mark Cuban is now calling for stablecoin regulations after this incident. Is that even necessary? Most of the blame is really on the developers, though it was not intentional. What happened is a lesson many can learn from in the DeFi space. There is no such thing as a perfect protocol or project that will continue to sustain insanely large yields. The liquidity is temporary because the moment whales begin removing their liquidity, things take a different turn. Be careful of the risk involved with protocols that promise high yields and massive returns. It can also lead to massive losses that are irrecoverable for investors. If incidents like these continue, perhaps that is when regulation becomes necessary.

Photo Banner Credit: Andrea Piacquadio

First Published on The Capital — (7/6/21)

Disclaimer: This is not financial advice. The information provided is for educational and reference purposes only. Always do your own research to verify facts.

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Vincent Tabora

Vincent Tabora

Editor HD-PRO, DevOps Trusterras (Cybersecurity, Blockchain, Software Development, Engineering, Photography, Technology)