Original | Odaily Planet Daily (@OdailyChina)
DeFi is once again at the center of attention.
As one of the most vibrant narrative directions in the industry over the past few years, DeFi carries the hopes for the continued evolution and expansion of the cryptocurrency industry. Believing in its vision, I have been accustomed to deploying over 70% of my stablecoin positions into various on-chain yield strategies, willing to take on a certain level of risk.
However, with the recent fermentation of multiple security incidents, the interconnected impacts of some historical events and the inherent issues that were originally hidden beneath the surface have gradually been exposed, creating a dangerous atmosphere throughout the DeFi market. Therefore, I personally chose to consolidate the majority of my on-chain funds last week.
What exactly happened?
Upper Chapter: Opaque High-Yield Stablecoins
Last week, several noteworthy security incidents occurred in DeFi. If the theft of Balancer was an unexpected isolated case, then the consecutive depegging of two so-called yield-bearing stablecoin protocols, Stream Finance (xUSD) and Stable Labs (USDX), exposed some fundamental issues.
The commonality between xUSD and USDX is that both are packaged as synthetic stablecoins similar to Ethena (USDe), primarily utilizing delta-neutral hedging arbitrage strategies to maintain their peg and generate yield. Such yield-bearing stablecoins have flourished in this cycle, as their business models are not particularly complex, and with the prior success of USDe, a plethora of stablecoins have emerged, even experimenting with every possible combination of the 26 letters of the alphabet and the term USD.
However, the reserve and strategy conditions of many stablecoins, including xUSD and USDX, are not transparent enough, yet under the stimulation of sufficiently high yields, these stablecoins still attracted a large influx of funds.
In relatively calm market fluctuations, these stablecoins could still maintain operations, but the cryptocurrency market is always subject to unexpected large-scale volatility. Trading Strategy analysis states (see “In-Depth Analysis of the Truth Behind xUSD's Depegging: The Domino Crisis Triggered by the October 11th Crash”) that the significant depegging of xUSD was primarily due to Stream Finance's opaque off-chain trading strategy encountering "automatic deleveraging" (ADL) during the extreme market conditions on October 11 (for a detailed explanation of the ADL mechanism, see “Detailed Explanation of the ADL Mechanism in Perpetual Contracts: Why Does Your Profitable Trade Get Automatically Liquidated?”), which broke the originally delta-neutral hedging balance. Stream Finance's overly aggressive leverage strategy further amplified the impact of the imbalance, ultimately leading to Stream Finance being essentially insolvent and xUSD completely depegging.
The situation with Stable Labs and its USDX should be similar. Although its official announcement later attributed the depegging to "market liquidity conditions and liquidation dynamics," considering that the protocol has consistently failed to disclose reserve details and fund flow specifics as requested by the community, coupled with the suspicious behavior of the founder's address collateralizing USDX and sUSDX on lending platforms while borrowing mainstream stablecoins at rates exceeding 100%, the situation of this protocol may be even worse.
The conditions of xUSD and USDX expose serious flaws in the emerging stablecoin protocol model. Due to the lack of transparency, these protocols exhibit a significant black-box space in their strategies. Many protocols claim to be delta-neutral models when promoting themselves, but the actual position structures, leverage multiples, hedging exchanges, and liquidation risk parameters are not disclosed, making it nearly impossible for external users to verify whether they are truly "neutral," effectively becoming a party that bears the transferred risks.
A classic scenario for the outbreak of such risks is when users invest mainstream stablecoins like USDT and USDC to mint emerging stablecoins like xUSD and USDX to earn attractive yields. However, once the protocol encounters issues (and it must be noted that there is a distinction between real issues and staged events), users find themselves in a completely passive position, and their stablecoins may quickly depeg under panic selling. If the protocol is conscientious, it might offer some compensation from remaining funds (even if compensation is offered, retail investors are often last in line), but if it is not, it could simply soft exit and leave the situation unresolved.
However, it would be unfair to dismiss all delta-neutral yield-bearing stablecoins. From the perspective of industry expansion, actively exploring diverse yield paths through emerging stablecoins has its positive significance. Some protocols, represented by Ethena, provide clear disclosures (Ethena's recent TVL has also significantly shrunk, but the situation is different; Odaily will write another article on this later). However, the current situation is that you do not know how many undisclosed or inadequately disclosed protocols have encountered similar issues as xUSD and USDX — while writing this article, I can only assume innocence, so I can only use "explosive" protocols as examples, but from the perspective of my own position safety, I would recommend you assume guilt.
Lower Chapter: Lending Protocols and Curators
Some may ask, can't I just avoid these emerging stablecoins? This leads us to the two main characters in the second half of this round of systemic risks in DeFi — modular lending protocols and Curators (the community seems to have gradually become accustomed to translating it as "Curator," and Odaily will directly use this translation below).
Regarding the positioning of Curators and their role in this round of risks, we provided a detailed explanation in last week's article “What is the Role of Curators in DeFi? Could It Be a Hidden Danger in This Cycle?”. Interested readers can directly refer to that article, and those who have read the original can skip the following paragraphs.
In short, professional institutions like Gauntlet, Steakhouse, MEV Capital, and K3 Capital act as Curators, packaging relatively complex yield strategies into user-friendly funds on lending protocols like Morpho, Euler, and ListaDAO, allowing ordinary users to deposit mainstream stablecoins like USDT and USDC with one click to earn high yields, while the Curators decide the specific yield strategies for the assets on the backend, such as allocation weights, risk management, rebalancing cycles, withdrawal rules, and so on.
Since this type of fund pool model often provides more attractive yields than classic lending markets (like Aave), it naturally attracts a surge of funds. Defillama shows that the total scale of fund pools operated by various Curators has rapidly grown over the past year, briefly surpassing $10 billion at the end of October and the beginning of this month, and as of the time of writing, it is still reported at $7.3 billion.
Curators' profit paths mainly rely on performance sharing and fund pool management fees, which means that the larger the scale of the fund pools they manage and the higher the strategy yield, the greater their profits. Since most deposit users are not sensitive to brand differences among Curators, their choice of which pool to deposit into often depends solely on the apparent APY figures. This makes the attractiveness of fund pools directly linked to strategy yield, so the yield of the strategy becomes the core factor determining the profit situation of the Curators.
Under the yield-driven business logic, coupled with the lack of clear accountability paths, some Curators have gradually blurred the safety issues that should be prioritized, choosing to take risks — "after all, the principal is the user's, while the profit is mine." In recent security incidents, Curators like MEV Capital and Re7 allocated funds to xUSD and USDX, indirectly exposing many users who deposited through lending protocols like Euler and ListaDAO to risks.
However, the Curators cannot bear all the blame; some lending protocols are equally culpable. In the current market model, many deposit users are not even fully aware of the role of Curators, simply believing they are depositing funds into a well-known lending protocol to earn yield. In this model, lending protocols play a more explicit endorsement role and also benefit from the surge in TVL, so they should take on the responsibility of monitoring the strategies of Curators, but evidently, some protocols have failed to do so.
To summarize, a classic scenario for such risks is when users deposit mainstream stablecoins like USDT and USDC into a lending protocol's fund pool, but most are unaware that Curators are using the funds to run yield strategies and are unclear about the specific details of the strategies. The backend Curators, driven by profit margins, then deploy funds into the aforementioned emerging stablecoins; after the emerging stablecoins explode, the fund pool strategy fails, and deposit users indirectly suffer losses. Then, the lending protocol itself may face bad debts (it seems that timely liquidation would be better; forcibly locking in the depegged stablecoin's oracle price to avoid liquidation could exacerbate the problem due to large-scale hedging loans), causing more user groups to be affected… In this pathway, risks are systematically transmitted and diffused.
Why has it come to this?
Looking back at this cycle, the trading side has already entered a hellish difficulty.
Traditional institutions only favor a very small number of mainstream assets; altcoins are in a continuous decline with no bottom in sight; the meme market is rife with insider manipulation and machine programs; and coupled with the massacre on October 11… a large number of retail investors have merely been running alongside or even incurring losses in this cycle.
Against this backdrop, the demand for wealth management, which appears to be a more certain path, has gradually increased. Additionally, with the milestone breakthroughs in stablecoin legislation, a large number of emerging protocols packaged as yield-bearing stablecoins have emerged in bulk (perhaps these protocols should not even be called stablecoins), throwing olive branches to retail investors with annualized yields of dozens of points or even more. Among them, there are certainly outstanding performers like Ethena, but there are also inevitable mixed results.
In the highly competitive yield-bearing stablecoin market, to make the product's yield more attractive — there is no need for long-term sustainability, just maintaining better data until the token issuance or exit — some protocols may seek higher yields by increasing leverage or deploying off-chain trading strategies (which may be completely non-neutral).
At the same time, decentralized lending protocols and Curators have aptly addressed some users' psychological barriers regarding unknown stablecoins — "I know you're uneasy about depositing into xxxUSD, but you're actually depositing USDT or USDC, and the Dashboard will also show your positions in real-time. Can you still be uneasy about that?"
The operational status of the above model has been relatively good over the past year, as there have been no large-scale explosions for an extended period. Since the market has generally been in a relatively upward phase, there has been sufficient basis arbitrage space between the spot and futures markets, allowing most yield-bearing stablecoin protocols to maintain relatively attractive yield performance. Many users have relaxed their vigilance during this process, with double-digit stablecoin or fund pool yields seemingly becoming the new norm for wealth management… but is this really reasonable?
Why do I strongly recommend you to retreat temporarily?
On October 11, the cryptocurrency market suffered an epic bloodbath, with hundreds of billions of dollars in funds being liquidated. Evgeny Gaevoy, founder and CEO of Wintermute, stated at the time that he suspected some protocols running long-short hedging strategies had suffered severe losses, but it was unclear who had incurred the largest losses.
In hindsight, the consecutive explosions of so-called delta-neutral protocols like Stream Finance partially confirmed Evgeny's suspicions, but we still do not know how many hidden dangers remain underwater. Even for those not directly affected by the liquidation on that day, the rapid tightening of market liquidity after the October 11 crash, combined with the contraction of basis arbitrage space due to cooling market sentiment, will increase the survival pressure on yield-bearing stablecoins. Various unexpected incidents often occur during such times, and due to the complex interwoven relationships underlying various opaque fund pool strategies, the entire market is prone to a "single thread pulling the whole body" situation.
Data from Stablewatch shows that as of the week of October 7, yield-bearing stablecoins experienced the largest outflow of funds since the collapse of UST during the Luna crisis in 2022, totaling $1 billion, and this outflow trend is still ongoing. Additionally, data from Defillama indicates that the scale of fund pools operated by Curators has shrunk by nearly $3 billion since the beginning of the month. It is clear that funds have reacted to the current situation through their actions.
DeFi is also subject to the classic "impossible triangle" of investment markets — high yield, safety, and sustainability can never be satisfied simultaneously, and the current factor of "safety" is teetering on the brink.
You may have become accustomed to investing funds into a certain stablecoin or strategy for yield, and have obtained relatively stable returns through this operation over a long period. However, even products that consistently use the same strategy do not have a static risk profile; the current market environment is one where the risk coefficient is relatively high, and unexpected incidents are most likely to occur. At this time, caution is paramount, and a timely retreat may be a wise choice, as when a low-probability event happens to oneself, it becomes 100%.
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