How The Collapse Of One Small Crypto Project Exposed A Serious Flaw In The Market

How The Collapse Of One Small Crypto Project Exposed A Serious Flaw In The Market
Reda Farran, CFA

about 2 years ago7 mins

  • Wonderland unraveled last week, and the ensuing chaos spread to Abracadabra, stablecoins MIM and UST, blue-chip crypto project Terra, protocol Anchor, and more.

  • That's because most DeFi users borrow money from one protocol to yield farm at another or magnify existing crypto bets, all of which increase the risk of contagion.

  • Beware of crypto projects with unrealistic returns, anonymous founders, and fake DAO promises, avoid Olympus DAO forks, consider liquidity when investing, and remember that stablecoins are not entirely risk free.

Wonderland unraveled last week, and the ensuing chaos spread to Abracadabra, stablecoins MIM and UST, blue-chip crypto project Terra, protocol Anchor, and more.

That's because most DeFi users borrow money from one protocol to yield farm at another or magnify existing crypto bets, all of which increase the risk of contagion.

Beware of crypto projects with unrealistic returns, anonymous founders, and fake DAO promises, avoid Olympus DAO forks, consider liquidity when investing, and remember that stablecoins are not entirely risk free.

Last week saw the spectacular collapse of crypto project Wonderland, whose native token dropped more than 60% in value. And while Wonderland is a relatively small-scale affair, the slip-up sent shockwaves through the wider crypto market and exposed its vulnerability to even a relatively minor upset. So here’s how the project came apart at the seams, how it impacted the wider crypto ecosystem, and what this episode can teach you going forward.

What is Wonderland exactly?

Wonderland is the first fork of Olympus DAO and was arguably the most successful one, at one point even exceeding Olympus in size.

Just like Olympus on Ethereum, Wonderland’s goal is to create a decentralized, policy-controlled, and reserve-backed currency system on the Avalanche ecosystem. The project’s native coin, TIME, is backed by assets in Wonderland’s treasury that it acquires through a mechanism called minting. This allows users to deposit various coins into the treasury in exchange for discounted and newly minted TIME tokens. The protocol earns a profit from minting that it distributes to users staking their TIME at an APY of over 80,000% (paid out in TIME tokens).

Check out my previous Insight on Klima DAO if you want to better understand where these staking rewards come from exactly. Note that minting in Wonderland is the same as “bonding” in Klima, and just as one KLIMA token is backed by one BCT token, one TIME is backed by one “MIM” from a minting perspective. MIM, or magic internet money, is a stablecoin algorithmically pegged to the US dollar.

What happened last week?

Wonderland was founded last year by prolific crypto developer Daniele Sestagalli and the pseudonymous Sifu, who also manages the project’s $700 million-plus treasury. Last Thursday, it emerged that Sifu’s real identity is Michael Patryn – the cofounder of a notorious Canadian crypto exchange that defrauded investors of upward of $190 million, and a convicted felon for identity theft and credit card fraud (among other things).

The revelation caused TIME to drop by more than 40% to an all-time low of $300 on Thursday. Consider too that TIME traded at a record high of more than $14,000 just a few months ago, bringing the current drawdown to over 97%. Unsurprisingly, the beleaguered project announced earlier this week that it’s shutting down.

How did this spread to other corners of the crypto market?

TIME’s market cap was under $500 million before the revelations came out, which doesn’t even put it in the top 100 of crypto projects by size. So how does a relatively small and supposedly isolated project like this cause damage to other corners of the market? Well, on top of dealing a negative blow to anonymity in decentralized finance (DeFi) more generally, you might be surprised to know that Wonderland, Sestagalli’s other projects, and other DeFi protocols are more interconnected than you think.

Sestagalli had known about Sifu’s real identity for at least a month, but chose to continue working with him and have him head up Wonderland’s treasury. Sestagalli might’ve even known from the start. In any case, Sestagalli’s reputation was questioned as a result of the news, causing his collective of projects – known as “Frog Nation” – to take a big hit. Making matters worse, Sifu was the chief financial officer of Frog Nation.

One of the collective’s projects is Abracadabra, a borrowing/lending protocol and issuer of MIM. Recall that MIM is a stablecoin algorithmically pegged to the US dollar, as well as a key asset in Wonderland’s treasury: there has to be one MIM token in the treasury for every single TIME token in circulation. That link between MIM and Sifu – as well as the prospect that Wonderland would (for a second time) sell MIM and other assets from its treasury to buy back TIME and halt its slide – was enough to drive investors to dump their own MIM.

All of this caused MIM to trade below its $1 peg, which led to fears of even further depegging, which caused even more selling. You can see from the chart below that MIM was trading 2% below its $1 peg last Friday – something no investor would want to see happening to their supposedly safe stablecoin holdings.

MIM depegged after the Sifu revelations. Source: CoinMarketCap
MIM depegged after the Sifu revelations. Source: CoinMarketCap

The MIM saga also impacted other stablecoins, namely Terra’s UST – the fourth-biggest stablecoin with a market cap of over $10 billion. That’s because Abracadabra offers a very popular product called “degenbox” that allows for leveraged yield farming using UST deposits. Users get newly minted MIM in exchange for depositing UST into the product, which then uses leverage to earn high interest rates on the UST using the Anchor protocol. But the whole dynamic means that MIM itself is heavily collateralized with UST. So when you combine a MIM selloff with investors reversing their positions in the degenbox, you get a selloff of UST – and pressure on its $1 peg too.

Like MIM, UST is an algorithmic stablecoin: it uses Terra’s native token, LUNA, to maintain its peg. If the UST is trading below a dollar, arbitrageurs mint $1 worth of LUNA by buying and burning one UST. They then immediately sell the newly minted LUNA to realize a risk-free profit. In summary, UST selling pressure leads to LUNA selling pressure, which can help explain why the blue-chip crypto – among the top ten biggest coins in the world – was the worst-performing DeFi coin on Friday.

LUNA was the worst-performing coin on CoinGecko’s DeFi category page. Source: CoinGecko
LUNA was the worst-performing coin on CoinGecko’s DeFi category page. Source: CoinGecko

This then had an impact on the Anchor protocol, widely considered the best stablecoin yield in DeFi (19.5% on UST). That’s because the protocol funds the bulk of this yield from staking rewards on LUNA that borrowers have put as collateral in Anchor. Lower LUNA price = lower rewards in $ terms = harder to fund the interest rate paid on UST deposits.

And the list of impacts goes on and on.

What can you take from all this?

First – and this applies to any investment, not just crypto – any promised returns that look too good to be true probably are. This is especially true if it’s coupled with a populist narrative being used to attract investors, which is how Daniele Sestagalli framed Wonderland.

Daniele Sestagalli on 5-Jan-2022. Source: Twitter
Daniele Sestagalli on 5-Jan-2022. Source: Twitter

Second, be very wary whenever the founders are anonymous. These crypto projects have weaker governance and are more likely to be scams, since there’s zero accountability when something goes wrong.

Third, stablecoins are not entirely risk free – especially algorithmic ones. As we saw last week with MIM (and, to a lesser extent, UST), there’s always a tail risk that they get depegged.

Fourth, avoid Olympus DAO forks. Many of them just copy-pasted Olympus and changed the title, and are essentially cash grabs. In fact, the biggest DeFi rug-pull of 2021 was a dog-themed Olympus DAO fork (two red flags in that one…)

Fifth, beware of any project masquerading as a DAO. A DAO (or decentralized autonomous organization) is a crypto community that’s owned and managed by its members. Decisions in a true DAO are made by the community: any token holder can put forward proposals, which the other token holders then vote on. In Wonderland’s case, key decisions were constantly taken by Sestagalli and Sifu with little community input, despite the project branding itself as a DAO.

Sixth, you always need to consider liquidity when investing. For example, some are currently making the argument that TIME is undervalued because it’s trading below the value of the assets that back it in Wonderland’s treasury. What’s more, there’s a proposal in motion to liquidate the treasury and return the funds to TIME token holders. Taken together, buying TIME today sounds like a good deal, right?

Well, the problem is that liquidating the Wonderland treasury isn’t as simple as it sounds. By my math, almost 40% of the treasury is either in MIM tokens or liquidity pair tokens that include MIM. But after last week’s episode, most MIM liquidity providers on stablecoin exchanges like Curve pulled out their money. Put simply: exchanging huge amounts of MIM to another stablecoin or cash might be virtually impossible for the Wonderland treasury at the moment due to a lack of liquidity.

Seventh, always watch out for contagion in crypto markets. This is related to a wider issue in DeFi at the moment. In traditional finance, people who borrow from a bank use the cash to buy a house or car, fund a new business, renovate a home, pay for education, and so on. But in DeFi, most users borrow money from one protocol to yield farm at another or magnify existing crypto bets.

There’s nothing strictly wrong with that (borrowers are free to do whatever they want with their loans as long as they pay it back), but it does introduce a lot of leverage into the system and increases the interconnectedness of DeFi protocols. So if something goes wrong at one, it could easily spread to other corners of the crypto market…

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