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The prevalence of DeFi (aka Decentralized Finance) has increased exponentially over the past year as investors and crypto fans alike have rushed to cash in on protocols that can replace everything from banking and hedge funds to insurance and prediction markets. As of writing, over $58 billion in U.S. dollars are locked within various protocols, an increase of over 39x since the same time last year. And the market shows limited, if any, signs of stopping, as new DeFi protocols are seemingly released every week.
While the DeFi markets have a lot to offer by way of circumventing centralized companies that typically offer finance, banking, and other services, DeFi is not without substantial risks. Triple-digit annualized returns and moonshot token prices are followed by crash and burn endings as often as not. Such was the case earlier this week with IronFinance, the latest DeFi darling to come crashing down to earth.
What is IronFinance?
IronFinance is a partially-collateralized stablecoin protocol that originally launched on the Binance Smart Chain in March 2021 before expanding to the Polygon network in May 2021, likely to take advantage of Polygon’s low fees and its connection to the Ethereum blockchain and resident DeFi ecosystem. IronFinance’s main offering is the IRON Stablecoin, which it bills as being “soft-pegged to the U.S. Dollar”. In other words, the Iron Stablecoin is not pegged to the value of the U.S. Dollar by 1:1 collateralization with actual USD deposits like other stablecoins such as Centre’s USD Coin or TrustToken’s TrueUSD.
The IRON Stablecoin instead attempts to maintain its price parity with the U.S. Dollar by storing collateral within associated smart contracts and through the minting and redemption of IronFinance’s two share tokens, the STEEL token on the Binance Smart Chain and the TITAN token on the Polygon network. IronFinance describes the pegging process on its website in the following way:
If the price of the IRON token is less than one U.S. Dollar, then anyone can purchase it on the open market and redeem it for approximately one USD worth of value when there is a profitable arbitrage opportunity.
If the price of the IRON token is more than one U.S. Dollar, then anyone can mint it with the protocol for approximately one USD worth of value and sell it on the open market when there is a profitable arbitrage opportunity.
The IronFinance protocol also incentivizes users to hold onto its token by producing yield on idle collateral and then sharing the yield with token stakers via its built-in profit-sharing function. Shortly after the protocol’s release, many users received average daily returns of 2%-5%. IronFinance saw explosive growth, especially after expanding to the Polygon network, growing from less than $100 million in Total Value Locked (TVL) in mid-May 2021 to over $2 billion on June 14th. For many, including billionaire investor Mark Cuban, IronFinance could do no wrong.
Bank Runs are no Longer Exclusive to Traditional Finance
On June 16th, the value of the TITAN token cratered, falling from its all-time high north of $64 to less than $2 within just a few hours. The price chaos continued from there, with TITAN currently trading for fractions of a penny so soon after taking the DeFi world by storm.
In their post-mortem analysis, IronFinance’s development team indicated that the token was subjected to two separate periods of offloading by TITAN whales. While the token was able to shake off the first bout of whale selling without a significant amount of panic from the market, the second liquidation of whale holdings caused extensive panic-selling of the token by holders of all sizes as well as massive redemptions of the collateral backing the IRON stablecoin. Because the IRON stablecoin is only partially-backed by stable assets, an insufficient amount of collateral was available within the protocol to satisfy the incoming redemption demands. The protocol failed and took out massive amounts of users’ wealth on its way down.
Are Fully Collateralized Protocols the Way Forward?
The failure of the IronFinance protocol echoes the problems of the fractional reserve banking model used in traditional finance throughout the world. Banks and other financial institutions limit the amount of cash they have on hand through the lending of customer deposits and through the rehypothecation of non-cash assets that have been posted as collateral by customers. Typically, banks in the United States are required to keep only 5-10% of customer deposits as liquid cash. However, in response to the COVID-19 pandemic in 2020, the Federal Reserve reduced the reserve requirement to 0%, effectively eliminating banks’ responsibility to maintain any cash on hand to meet depositor redemption requests.
An argument can be made that fully collateralized or over-collateralized financial offerings would significantly reduce the possibility of reserves being insufficient to meet depositor redemption requests, even in times of extreme demand. And in fact various DeFi protocols, such as Aave and Compound, and centralized crypto lenders, such as Nexo and Celsius Network, have generated significant amounts of revenue using over-collateralization lending models. Depositors under such models face significantly reduced risks of losing their assets during a bank run or market panic as the value of associated collateral rarely dips below the value of their deposits.
Do Your Own Research
While under-collateralized DeFi protocols come with substantial risks for users, it seems unlikely that they will go away anytime soon. After all, they are a significant driver of yield farming and can often enable astronomical returns for users who are able to get into and out of the protocols unscathed.
As with any investment, it’s imperative that users research the DeFi protocols, their functionality, and their developer teams at length before risking any amount of money. And never risk more money than what you are willing and able to lose. Your financial gain or financial ruin will largely depend on the level of effort you put into protecting and growing any investment.
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