Event Summary

Original compilation: BlockTurbo

Event Summary

Silicon Valley Bank (SVB), with $209 billion in assets, was shut down by regulators on Friday, March 10, in the largest bank failure since the global financial crisis. Unlike the GFC bank failures caused by collateral risk mismanagement, the SVB failure was due to the Fed facing high inflation, which led to rapidly rising interest rates, exacerbating duration risk mismanagement. Duration risk arises when banks lock up too much money for investment over a long period of time and cannot meet short-term deposit and withdrawal needs. Once the situation at the bank spread on social media, depositors scrambled to withdraw their deposits, leading to a run on the bank and eventually the bank being taken over by the FDIC.

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While the decoupling event was sparked by concerns over USDC’s deposit reserves, DeFi fueled volatility. One of the largest USDC DEX pools is the Curve 3 pool, which assumes that all three of its stablecoins should be worth $1.00. However, when decoupling, centralized liquidity mechanisms and incentives can quickly lead to further price declines. Also, in other areas of DeFi, USDC is so trustworthy that the protocol has an assumption of $1.00 hard-coded. Most notable is Maker’s Pegged Stability Module (PSM), which supports the DAI peg. With a hard-coded USDC price, Maker and DAI absorbed a lot of risk and volatility, as arbitrageurs were able to use the price difference to move over $2 billion in USDC to PSM, more than doubling Maker’s USDC holdings.

While Circle’s $3.3 billion in SVB deposits may recover, the impact on DeFi will linger for months to come. For investors, the key areas to focus on are:

• Stablecoin supply: Where is the majority of USDC, and which ecosystems and protocols are most exposed?

• Liquidity: How easy is it to swap and move money with USDC? How has liquidity declined since the decoupling event?

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Stablecoin Supply

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The supply released by EOA holders was mostly absorbed by CEXs, as the balance held on exchanges increased by almost 50% in the past 14 days. This accounts for about half of the supply that EOA has dumped on the market. The other half is distributed in DeFi, i.e. in DEX pools and lending markets where holders seek tokens with no market risk or depeg risk. For example, as mentioned earlier, Maker’s PSM had nearly $2 billion in USDC inflows, while Curve’s 3 pool had $1.6 billion inflows as holders switched to other, more favorable tokens.

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Arbitrum is now the second largest ecosystem for USDC after Ethereum, following supply changes on other chains during the depeg event. Over the past two weeks, Arbitrum has seen USDC inflows of approximately $50 million, while ecosystems such as Solana, Polygon, and Avalanche have seen outflows of approximately $5 billion to $150 million over the same period. Over the past month, Arbitrum has maintained the highest TVL growth rate (rate of change) among the major ecosystems, indicating increasing activity.

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Stablecoin Liquidity

USDC is at the center of DeFi. The two core DEX pools are Curve 3 pool and Uniswap ETH<>USDC 5 bps pool. USDC is also the most liquid stablecoin on money markets like Aave and Compound, and accounts for the majority of DAI collateral. Therefore, USDC maintaining its peg and available liquidity is critical to DeFi operations.

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Uniswap has also seen similar results. Main USDC<>picture

Due to all the activity fleeing USDC and the resulting arbitrage opportunities, DEXs had one of their highest volume days ever. Transaction volume on March 11 hit a new high of nearly $25 billion. Uniswap accounted for a little over half of the total DEX trading volume ($12 billion), while Curve's $8 billion trading volume accounted for the other majority.

However, with all ideal counterparty liquidity drained, there is little way for remaining USDC holders to sell USDC without market risk or severe slippage. The only other venues to exit outside of CEXs are money markets and debt protocols like Maker.

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Compounding the liquidity problem, both Aave and Compound enacted emergency governance parameter changes to protect the protocol from bad debt in the event USDC continues to depeg. Aave ended up freezing the stablecoin market in its V3 Avalanche deployment because it was by far the most vulnerable to stablecoin pair bias through V3's efficiency model. Likewise, Compound froze new USDC deposits in its V2 protocol to reduce the introduction of new potential bad debts.

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Leverage and Liquidation

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What's next?

Through the events of this weekend, we can find that DeFi is overly dependent on USDC. However, the problem is not USDC, but rather the strict mechanical assumptions employed in DeFi protocols. A protocol that assumes that USDC or the blanket price is always equal to $1 hardcodes the USDC or blanket price. Such assumptions, as events have demonstrated, do not always hold.

We should aim to build DeFi protocols that are flexible enough to respond to market conditions with minimal assumptions.

For example, the Gyroscope protocol, a new stablecoin project, expresses this need for a dynamic design. The protocol uses a pegged stabilization mechanism called the Dynamic Stabilization Mechanism (DSM), which is Maker's theoretical modification of the rigid PSM. In effect, the DSM collateralizes Gyroscope stables with multiple other stables and dynamically adjusts the redemption price based on reserve levels, rather than assuming a $1 collateralized stable.

In addition to designing more dynamic systems, DeFi protocols should diversify stablecoins as much as possible without overly disrupting liquidity. This largely means designing more crypto-collateralized stablecoins like DAI. Aave and Curve are two projects launching stablecoins this year, offering a viable path for stablecoin adoption rather than relying on USDC.

With the USDC peg restored, DeFi is expected to return to normal business in the short term. In the long run, investors and users alike should look for projects that launch alternative stablecoins and protocols with dynamic designs that reduce risk.