Iron Finance collapse: first DeFi crash

On June 16, 2021, the IRON stablecoin lost its peg, dropping to 0.70 USD/token. Its TITAN governance token plummeted from 64 USD to zero value (0.00000105 USD), and the so-called Total Value Locked or TLV, which is the accumulated value in the protocol, went from 2.4 Bn to 29 million in less than 1 day. The purpose of this article is to try to explain the biggest banking panic and subsequent crash in the still short history of the DeFi…

Explaining the Iron Finance protocol

TITAN is a governance token created by Iron.Finance, which is a multi-chain protocol, to fund the development of IRON. IRON, meanwhile, is a partially collateralized stablecoin available on the Polygon blockchain (Matic) and Binance Smart Chain. The protocol aims to offer a stablecoin, ensuring the peg with the dollar by storing sufficient collateral in temporary smart contracts. In this sense, it can be said that Iron Finance follows an assimilated fractional reserve model.

It is a partially collateralized stablecoin, such that IRON is supported by other stablecoins (USDC/BUSD) for 75%, and other volatile assets for the remaining proportion (TITAN/STEEL). In fact, the TITAN token is a governance token, created specifically to guarantee peg by minting or burning it, and whose holders define the actionable levers of that protocol.

The collateral used is:

  • Polygon (Matic): USDC and TITAN Token.
  • Binance Smart Chain: BUSD and STEEL Token.

When a user mints or generates IRON, USDC and TITAN are deposited into the corresponding Liquidity Pool, thereby increasing the demand for TITAN. When a user redeems IRON, he receives USDC or TITAN.

What is a Liquidity Pool?

It is an automated liquidity protocol used to exchange pairs of tokens in a decentralized manner. It assigns the price algorithmically against market makers that provide liquidity and generate profitability for it. They are structured through a set of Smart Contracts, which allows three types of operations: swap, send and pool.

  • SWAP: exchange of an A token for a B token.
  • SEND: sending of token A by user A to user B.
  • POOL: provision of liquidity to an exchange pool and earning a return. The liquidity provider provides the two tokens in the proportions that reflect the exchange rate, and the protocol sends governance or reward tokens to the user that represent the percentage of participation in the pool and the accumulated interest earned (derived from the fees applied in the swap operations performed by the users. These are accumulated in the governance tokens).

Going back to Iron Finance, the ratio that relates the level of USDC and TITAN is called Target Collateral Ratio and Effective Collateral Ratio. In addition, the peg is regulated by supply and demand incentives, since any buyer can acquire IRON below 1 USD and redeem it by acquiring USDC + TITAN, with the consequent profit after the sale of TITAN, and short when IRON is trading above 1 USD, sell it, and repurchase it for 1 USD.

Additionally, IRON produces a return for token holders through the reinvestment of both IRON and USDC in liquidity pools. This process, called yield farming or liquidity mining, allows users who acquire and hold IRON to earn an additional return on TITAN, as implied by the POOL (APY or Annual Percentage Yield) function. This LPs vary significantly, as they allow to swap different pairs (IRON/USDC, IRON/MATIC, TITAN/IRON, among others). In other words, they exchange the loss of liquidity by allocating it in an exchange for the returns obtained through the reward associated with the governance token of the pool they receive to which they have contributed this liquidity. In other words, by allocating both USDC and IRON, for example, they receive TITAN, which is the governance tokens through which all the rewards are given.

The Liquidity Pools generated under the Polygon ecosystem require TITAN token allocation and are in high demand, as they generate very strong returns and Polygon’s transaction costs are practically non-existent. Moreover, as the access platforms to these Liquidity Pools are auto compounding protocols of DeFi, they allow to capitalize the returns generated by reinvesting the reward in other Liquidity Pools, which further increases the demand for them. In fact, the IRON ecosystem included more Liquidity Pools in other protocols (such as SushiSwap or QuickSwap) in which to continue the yield farming procedure through TITAN contribution.

The risk of allocating TITAN lies in the fact that potential losses of profitability in Polygon’s liquidity pools could cause the value of TITAN itself to fall due to a drop in demand, and this in turn could drag down IRON, since the peg of IRON depends partially on TITAN itself. In other words, Iron Finance’s stabilization mechanism, which is based on minting TITAN and its subsequent sale in the market to acquire IRON, redeem it and through this reduction in the money supply increase the value of IRON until it returns to peg, collapses when the demand for TITAN falls.

In this case, the very structure on which the stablecoin is based, which is based on a partial reserve of stablecoins, may affect its stability. IRON’s main stabilization mechanism, based on supply and demand, was affected by the fall in the value of TITAN, as the APY derived from its allocation in the Liquidity Pools changed. In other words, the sale of some TITAN institutional holders generated a fall in the value of the token, which in turn dragged the IRON par down with no possibility of stabilizing it by issuing TITAN. And this in turn, triggers additional TITAN sales.

Similarities with the banking world:

In banking, this is known as a banking panic, which only impacts in the fractional banking system, and by building IRON as a partially collateralized stablecoin, it exposes itself to the same risk. Therefore, banks establish risk management systems by hedging such liquidity through [1]stressed ratios, which measure the bank’s ability to guarantee coverage of deposit outflows in a stressed scenario for 30 days, with no inflow of new assets. Why? Because the bank deposit holders are the retail world, and in exchange for liquidity contributions (with potential profitability derived from deposit interest rates), the regulator protects them, requiring guarantees from credit institutions in terms of compliance with risk management standards specified in qualitative (governance, internal control) and quantitative (metrics) aspects.

In the current context of bearish trends and market shocks, the behavior of stablecoins and their ability to maintain their peg with the currency against which they are benchmarked can be analyzed within the framework of Stress Tests. Stress tests are stress exercises that aim to quantify the variation in terms of a given metric resulting from a systemic, idiosyncratic or combined shock, the severity of which is previously determined by a supervisory authority in charge of validating such tests. The aim is to identify whether the structure of the entity subjected to the stress test is capable of assimilating the shocks in question.

Could this shock be understood as a Stress Test for stablecoins?

Although in the banking world such exercises are commonplace, and constitute a supervisory tool for the authorities (to the extent that they can generate additional capital or liquidity obligations for the entities in case they are not able to overcome the theoretical thresholds set), they have also been included in MiCA[2] as part of the supervisory exercise of CASPs or Cryptoasset Service Providers and stablecoins. As these are cryptoassets issued by entities subject to regulation, with the potential to impact financial stability, the regulator wants to ensure that they do indeed respond correctly in a stressed scenario.

However, the EBA (European Banking Authority) and the ECB (European Central Bank) have never conducted stress exercises on financial instruments or assets, but on regulated entities. In the current paradigm, it is the balance sheets of credit institutions that are subjected to shocks from different perspectives, analyzing aspects as the followings: the behavior of the credit portfolio and the potential increase in the probability of debtors’ default, the stress deriving from excessive price volatility, a change in interest rates, or even impacts on liquidity due to closure or decrease in wholesale funding, closure of repo markets or the interbank market and massive outflows of deposits, which are the basis of European credit institutions’ funding. In other words, the authorities propose thematic stress tests by type of risk, but always based on the institution’s balance sheet.

Thus, in this case, the need arises to identify hypotheses that can stress the behavior of a cryptocurrency, to verify whether it effectively fulfills its purpose when the natural mechanisms of minting and burning, or even the supply and demand incentive systems ,are altered. And in the case of stablecoins, the main fundamental point of analysis to ensure their use as a means of payment is their stability, measured in terms of their ability to maintain peg in stressed markets.

[1] LCR or Liquidity Coverage Ratio, regulated in Europe through Delegated Act 2015/61/EU.

[2] Proposed European Regulation on Crypto Assets (Market in Crypto Assets)