Defi Bummer: The Sorrows of Dani Sesta

By Christopher Kilbourn | Crescent City Capital Market Analyst Intern

Few are the occasions when crypto and cancel culture get in bed together, but last week appears to have been one of them.  That Dani Sesta is at the heart of the scandal may come as a lesser surprise to some – in retrospect, it’s no particular shock that the man who brought the phrase “degenbox of Magic Internet Money” into serious financial discourse might have courted controversy.   Nobody, however, predicted that the treasurer of Avalanche’s premier OHM fork would turn out to be an ex-con with an 18-month bid in federal prison under his belt by the age of 23. 

Both manage to spice up a notoriously dry conversation about the innerworkings of decentralized finance, so perhaps we can seize upon the opportunity to investigate further.  For while the lurid details seem little more than a good headline, the outcome was a serious destabilization of several defi protocols, and the situation offers an object lesson in how these projects functioned.  Now is as good a time as any to learn about the mercenary liquidity problem and the perils of defi, and thus be better able to judge the solutions provided by future investment opportunities.   

Matters of Liquidity

At its heart, defi consists of blockchain projects that replace the institutions of banking with automated smart contracts.  In the same way that a homeowner might use a house as collateral for a loan, or a depositor may place money in a bank, defi users can send tokens to a contract to borrow money or be paid interest.  The flagship application of decentralized finance, perhaps the basis for all others, is the decentralized exchange.  To this we turn for the critical task of exchanging tokens on chain without the intermediary of a private bank of corporation.  Sparing the gory details for the time being, take it on good faith that liquidity is the basis for any DEX’s success.  Nothing is more important when exchanging tokens than finding a narrow spread between ask and bid, and to that end, users will naturally seek the exchange with the greatest amount of liquidity.

We arrive now at the first issue.  Who provides this liquidity and why?  There’s a word for centralized liquidity providers: they’re called banks, and we don’t like them.  So who are the liquidity providers in a decentralized exchange?  The answer, fellow degen, is you and I.  Defi revolves in essence around incentivizing users to provide peer-to-peer liquidity.  When a user contributes a pair of tokens in equal amounts to an automated market maker’s liquidity pool, they are paid reward tokens as interest, generally at unheard of and borderline unconscionable APY. 

The Rent is Too High

Here’s the thing.  In order to attract competitive amounts of liquidity, protocols will incentivize liquidity providers at ever-increasing competitiveness.  One outcome of this is an undesirable emissions rate, resulting in inflationary tokens with no hope of delivering the 10,000X return to which its investors are rightfully entitled.  The other is the encouragement of “Liquidity locusts,” or mercurial liquidity providers who only contribute so long as the incentives are kept artificially high. 

2021’s most creative answer to this problem came in the form of Olympus DAO.  Rather than having liquidity providers lock tokens on the contract and essentially paying interest on the loan, Olympus devised a novel bonding solution.  Simply put, providers sell their liquidity pairs to Olympus in exchange for discounted OHM, and the Olympus treasury keeps their tokens for good.  This system of protocol owned liquidity has two major advantages for Olympus.  By amassing gigantic reserves of every currency imaginable and providing liquidity on their own, Olympus gets to keep the trading fees that normally get distributed to liquidity providers on rent-based DEXs.  But more importantly, it means that Olympus doesn’t lock other people’s liquidity on their protocol, it owns the treasury itself – and thus, OHM is not pegged or collateralized, but backed. 

The Run on TIME

Olympus’s idea gained a good deal of traction following its release, and OHM forks abounded throughout 2021.  One of the more prominent of these is Wonderland on the Avalanche ecosystem, formed by a public-facing founder named Daniele Sestagalli and an anonymous team of developers.  When news came out last week that one of these developers was Michael Patryn – convicted in 2007 for selling stolen credit card numbers and affiliated with a failed Canadian crypto exchange that cost investors $169 million – investors were understandably miffed.  The price of TIME cratered and Sestagalli was subjected to intense scrutiny over his willingness to trust a man convicted of grand theft with the $712.9 million Wonderland treasury.

As is commonly the case, the issue proved contagious.  Sesta is also responsible for a lending protocol called Abracadabra, which appears for all intents and purposes to be a Maker clone marketed towards 7-year-olds.  Therein, degenerate youngsters can open a vault on the contract, collateralize it with various currencies, and borrow the native MIM stablecoin against their own holdings – all while cosplaying a wizard casting spells across an 8-bit cartoon world.  The whole thing has a Joe Camel quality that may turn some users off, but at the end of the day there’s just no accounting for taste. 

What ties Abracadabra and thus the Sifu scandal into the outside world were the colossal UST holdings that users had locked on Abracadabra’s protocol, which Sesta subsequently leveraged, rehypothecated, and staked on Terra’s Anchor protocol.  As investors dumped all the MIM they could, they returned to Abracadabra to withdraw UST, causing a run on the protocol’s treasury and a correlated selloff that temporarily broke UST’s peg with the US dollar.  With Sesta having leveraged the stablecoin to the point of a $0.97 liquidation price, any serious imbalance in the liquidity pools could have resulted in a liquidation and spelled disaster for Anchor.  At its peak, Abracadabra accounted for $1B of Anchor’s $6B TVL, and a liquidation of this collateral could have sent shockwaves far beyond the world of Sesta’s involvement.  Disaster was narrowly avoided, Terra restored its peg, and the system healed faster than a Luna tattoo on Mike Novogratz, fresh on the heels of his New Year’s in New Orleans.   

Reflections

The revelation of Dhanani’s involvement shines a light on a genuine vulnerability inherent to the nature of crypto.  In a sense, blockchain technology exists for the explicit purpose of replacing human institutions with immutable protocols, and in doing so, it creates a bulwark against human corruptibility.  While the anonymity this makes possible is considered an indispensable feature to many users, it can also inhibit users’ ability to judge a protocol by the reputation of its founders. 

What nobody seems to be discussing in this story is that with the advent of the Olympus-style protocol-owned-liquidity system, the management of treasuries becomes a larger part of defi protocol governance.  And whether a financial entity happens to be centralized or decentralized, wherever a human manages a $712.9 million portfolio with no regulatory framework in place overseeing his management, there is manifest potential for bad faith decision making.   Anyone considering investing in this style of defi protocol would be wise to do considerable research on both the investment activities of the treasury and the human beings responsible for conducting it. 

Secondly, with regulation at the forefront of everyone’s mind, this is one more reason for suspicion of a space that lacks legal oversight not only over its financial instruments, but increasingly over the reserve currencies that are used to buy them.   Stablecoins stand directly in the crosshairs of congressional inquiry and these developments will only make the coming debate rockier and more contentious.  With regulatory uncertainty likely to be one of the primary sources of volatility in the crypto space this year, this is one more reason to expect anything but smooth sailing over the coming months.