TLDR
- Stablecoins are designed to trade at a fixed exchange rate to US dollar. They are liabilities of the issuing protocol (like bank deposits) and thus must be backed by assets.
- Algorithmic stablecoins like Iron Finance’s IRON use endogenous assets (e.g. TITAN) that are issued by the protocol with or without exogenous assets (e.g. USDC), making them fragile and more exposed to a potential asset-liability mismatch and run risks that can result in a self-reinforcing downward spiral.
- We show that Iron Finance stablecoin fails when the protocol suffers from a large withdrawal shock. This can happen to all algorithmic stablecoins.
Citation
Saengchote, Kanis. “A DeFi Bank Run: Iron Finance, IRON Stablecoin, and the Fall of TITAN.” Puey Ungphakorn Institute for Economic Research discussion paper No. 155 (2021).
Core Research Question
Can an algorithmic stablecoin fail from a large withdrawal shock?
Background
- Stablecoin: A fungible token (e.g. ERC-20) designed to trade at a fixed exchange rate based on some numerical value e.g. USD. There are many ways to instill trust among buyers and sellers, but they are mostly based on the ability to redeem for something with equivalent value.
- Iron Finance: A DeFi protocol that issues two ERC-20 tokens on the Polygon blockchain: TITAN and IRON. TITAN is issued as a rewards, and IRON is minted (bought from the protocol) when participants send $1 worth of USDC (another stablecoin) and TITAN to the protocol and can be burned (sold to the protocol) for $1 worth of USDC and newly issued TITAN. Thus, IRON is a dollar-denominated stablecoin, and its value is “algorithmically” secured by the burning and minting of TITAN.
- Bank run: a situation in which a financial institution that has liquid liabilities (e.g. deposits) cannot meet redemption demands because of mismatched assets, causing a withdrawal spiral and ultimately its failure.
Summary
- Algorithmic stablecoins provide a more “capital efficient” way of creating stablecoins in a decentralized manner (that is, without relying on external, off-chain assets) as they do not require as much collateral as other models. Stablecoins also rely on algorithms and participants’ actions to arbitrage prices to the intended peg.
- Participants react to arbitrage opportunities in a way that restores peg parity, but the mechanism can fail when the system suffers from a large shock in the shape of sudden, large liquidity withdrawal.
- Thus, algorithm stablecoins are fragile because of their reliance on the value of endogenous tokens, creating a potential asset-liability mismatch risk.
Method
- This paper visualizes granular transaction data obtained directly from the Polygon blockchain to show how participants react during the critical hours of the Iron Finance “bank run”.
- Detailed data allows investigation of whether participants behave according to the mechanism design of the protocol. When arbitrage opportunities exist, do participants respond to them? Ordinary least square (OLS) regressions are used to detect the relationship between arbitrage opportunities (taking into account transaction costs such as swap fees but excluding blockchain gas fees, which are very low for the Polygon blockchain) and participants’ behavior at 10-minute intervals.
Results
- Participants interact with the protocol as designed, reacting to arbitrage opportunities under normal times. When IRON trades below $1, participants buy IRON to profitably redeem for TITAN, which can be sold for profit.
- However, if the prices of both IRON and TITAN are falling (triggered by a sudden, large removal of liquidity), the protocol can enter a downward spiral similar to a self-fulfilling panic. As IRON is arbitraged, more TITAN is minted which exerts further downward pressure on TITAN price.
- Participants who observe this situation unfold may have lost confidence in the protocol and further withdraw their liquidity, turning this into a self-fulfilling panic like the classic bank run.
- The price of IRON settles around $0.75, close to the value of the USDC reserves available per IRON. While it is technically possible to buy IRON for $0.75 for arbitrage profits, participants seem disinterested.
Discussion and Key Takeaways
- The financial system is based on trust, some of which can be automated using computer code. Here, computer code guarantees that 1 IRON is redeemable for $1 of USDC and TITAN, but the mechanism fails to restabilize. There are four important key takeaways here.
- First, it might be because when TITAN price rapidly declines to unfamiliar territory – from $64.32 to 6 x 10-8, participants may choose to abandon (flight to safety) and sell both TITAN and IRON rather than arbitrage.
- Second, TITAN is traded in limited places (mostly on-chain swap pools and not on centralized exchanges). Also, participants must swap USDC for IRON in one of the 2 USDC-IRON pools (other choices are TITAN-IRON and IRON-WMATIC, but not as deep as the stablecoin pools), but the same pools are also exit routes as they swap IRON for USDC. This lack of “exit liquidity” may be part of what accelerates the downfall.
- Third, when participants lose their trust in TITAN, IRON collapses to the value of USDC. Stablecoins rely on trust in their redemption values. USDC is exogenous to Iron Finance, hence does not suffer the same demise. However, TITAN is endogenous and thus exposes the protocol to fragility. The loss of trust in Iron Finance is exemplified by the sharp drop in the price of TITAN is directly transmitted to IRON.
- Fourth, Iron Finance is 100% on-chain, so everything is open to see. There is research in experimental economics which shows that bank runs can be exacerbated when participants can observe the actions of one another. In an off-chain setting, participants may hear many rumors of why a bank may fail but not see evidence of withdrawal. In an on-chain setting, participants still hear rumors but can directly observe withdrawals, which can hasten their actions.
Implications and Follow-Ups
- Algorithmic stablecoins are fragile by design and relies on trust in the value of the endogenous assets.
- Trust may or may not be automatable with computer codes. Further studies can shed light on which circumstances “code is law” is sufficient.
Applicability
- Banks can be viewed as financial entities that issue debt-like liabilities (deposits) to finance mismatched assets (loans). A stablecoin issuer can thus be viewed as a “shadow” bank. If assets and liabilities are mismatched, a sudden withdrawal can trigger a run.
- For algorithmic stablecoins, the assets backing the issued liabilities (stablecoins) are more precarious because they comprise endogenous assets with or without exogenous assets. The greater reliance on endogenous assets, the more likely a self-reinforcing spiral can occur, and the lower the “floor” price of the stablecoin.