Bancor, a pioneer in Decentralized Finance, temporarily halted its popular impermanent loss (IL) insurance feature last weekend, raising concerns that the protocol isn’t truly “decentralized.”
Impermanent loss refers to the unrealized amount that occurs when you provide liquidity to a pool in the form of cryptocurrency, and the value of those tokens changes since you deposited them.
Ever since the automated market maker said it wants to give the protocol room to breathe, it has observed wallets linked to crypto lenders Celsius and Nexo remove liquidity from the system while taking a haircut.
Blockworks spoke to Bancor’s Head of Growth Nathaniel Hindman and Head of Research Mark Richardson to understand what they saw as “manipulative behavior” that made them safeguard the protocol. The pair identified two major factors: large short positions taken out against the protocol’s BNT token, while at the same time a surge in withdrawals and selling of the liquidity mining rewards, which are paid out in BNT by the protocol.
Large short positions
In a June 19 blog, Bancor said it would temporarily pause IL for liquidity providers (LPs) due to an ongoing “attack” and a “hostile antagonist.” The attack, they believe, relates to wallets linked to Celsius’ attempt to exit large positions in the protocol. They found accounts on two exchanges, FTX and OKX, that held short interest worth $2.5 million in total against the platform’s BNT token.
“It’s not catastrophically large,” Richardson said in an interview. “But whoever is sustaining these positions is borrowing the maximum daily limit every day.” He assumed the rapid withdrawals were made to cover liquidations or debt.
“Because of the financial situation that they’re in, they are being a lot more reckless in the way that they’re managing their exit from the market,” he said.
Additionally, they believed someone spread misinformation on the message board 4chan about the way Bancor runs its protocol. That drove panic and led to a number of active withdrawals piling up, similar to a bank run, encouraging other people to follow — until a majority of the protocol’s Total Value Locked (TVL) was queued up to leave, according to the product architect.
Large withdrawals end up making BNT less liquid, which means the token is less able to absorb the selling pressure. But Bancor was built to deal with short interest, Hindman said — emphasizing that it wasn’t just this incident that led to the IL pause.
“It’s been this perfect storm of events.”
It’s not just the shorts,” he said. “It’s also having some of the largest centralized players in the industry utilizing our system, and then having them go insolvent at the same time and withdrawing and dumping large amounts of liquidity mining rewards.”
Bancor LP’s liquidity mining rewards “went on too long“
While decentralized exchanges like Uniswap don’t protect against impermanent loss, Bancor pitched such compensation as a unique selling point. LPs receive BNT tokens as rewards for committing their capital to Bancor pools. This was the “original sin” that caused headaches for the protocol, Hindman said.
“BNT liquidity mining rewards really went on too long,” he said, adding that large stacks have been accumulated in the hands of some people who are now rapidly dumping them, “putting this maximum strain on the system.”
So the combination of a market meltdown, substantial short positions and tons of BNT rewards being dumped simultaneously caused the team to intervene.
“We could see very easily that we weren’t going to be able to withstand that for much longer,” Richardson said.
There have been some concerns that Bancor simply mints new BNT to compensate liquidity providers under its ILP mechanism.
Does Bancor “impermanent loss protection” just pay out newly minted BNT tokens in order to cover the loss if there wasnt enough made in fees……???
— Cobie (@cobie) June 19, 2022
Hindman denied this by calling it a misconception. “Some of these criticisms have come from the biggest investors of some of our competitors and folks in the industry that just haven’t taken the time to understand this system,” he said.
He said Bancor operates similar to an insurance company, by offering the IL insurance in exchange for a percentage of trading fees on the network.
“Currently about 15% of trading fees are confiscated from liquidity provider earnings in order to fund the insurance, and that’s also on top of Bancor co-investing its BNT inside our own pools in order to generate protocol fees that offset this cost,” he said.
Minting of BNT is a last resort, only employed when the protocol fees, from trading activity, are not enough.
DAO emergency powers vs. centralized authority
Bancor said it had to activate its “emergency powers” in order to respond to the crisis, raising eyebrows about whether that goes against the fundamentals of a Decentralized Autonomous Organization. Technically, there isn’t supposed to be a centralized leadership group within a DAO.
But the Bancor team says they felt it necessary to assign emergency rights to certain people who can take decisions in a crisis.
“In these early days of decentralized protocols, especially those that are as complex as Bancor, we think it’s only responsible that the DAO give emergency rights to a multi-sig,” Hindman said, referring to a multi-signature wallet that manages protocol upgrades and parameters, providing a measure of centralized control.
“We weren’t going to sit by and watch as a community what we think was a small handful of large players suck the system dry.”
Bancor is now working to propose stronger protections for its IL insurance system to the DAO, even as independent observers question the viability of the whole system.
“We understand that it’s certainly controversial, but we do think it was the right decision to make,” said Hindman.