Decentralized Finance (DeFi) has unlocked innovative financial models, yet it remains susceptible to significant risks, especially during market downturns. This article explores recent challenges faced by THORChain (RUNE) and Kujira (KUJI), analyzes synthetic asset models, and compares ENA’s approach to Maker’s DAI.
THORChain (RUNE): Collateral Risks and Debt Spiral
THORChain’s recent challenges highlight the dangers of relying on a native token as collateral. The protocol’s innovative lending model involves:
- Collateral Conversion: Users deposit assets like BTC or ETH, which are sold for RUNE. By burning RUNE, the system aimed to keep its price up, which helped to offer loans without requiring liquidation, reducing risks for borrowers and encouraging them to keep their position.
- Loan Repayment: When loans are repaid, RUNE is minted to repurchase the original collateral from the market.
What Went Wrong?
- Market Dependency: RUNE’s price decline created a debt spiral. As liabilities exceeded the value of burned RUNE, minting more tokens caused further devaluation, undermining confidence.
- Inflationary Pressure: The reliance on RUNE as both the collateral and liability instrument proved unsustainable during a bear market.
- Lender Awareness: Many lenders likely did not fully understand how their assets were being used in this system, which underscores the importance of conducting thorough due diligence (DYOR) before participating in DeFi protocols.
This design reveals the vulnerabilities of self-referential token systems, particularly in volatile markets.
Kujira (KUJI): Governance and Operational Risks
Kujira’s collapse of operational funds due to on-chain liquidation underscores governance risks. The Kujira Foundation:
- Leveraged KUJI: The Foundation used KUJI—primarily sourced from the protocol’s operational treasury—as collateral to secure loans.
- Liquidation Event: Market volatility led to under-collateralized positions, triggering forced liquidation on its own platform. The price of KUJI plummeted, eroding investor confidence.
- Connection with THORChain: Kujira has partnered with THORChain to explore a shared DeFi application layer, but the financial issues of both protocols highlight the need for robust collaboration and risk management.
Lessons Learned:
- Collateral Management: Overleveraging native tokens can destabilize protocols.
- Governance Transparency: Community-driven treasury management may reduce single points of failure.
From Collateral Risks to Synthetic Assets: Evaluating ENA (USDe)
Synthetic assets aim to bring stability and utility to DeFi ecosystems. ENA introduces a novel approach:
- Mechanism: ENA creates a synthetic dollar by pairing long and short positions on perpetual markets.
- Utility: ENA enables decentralized trading and hedging strategies while maintaining a stable synthetic asset for DeFi use cases.
- Non-Self-Referential Model: Unlike systems such as Luna’s UST, ENA does not rely on its native token to stabilize its synthetic dollar, reducing the risk of a death spiral.
Governance and Utility of the ENA Token
ENA’s governance token serves multiple purposes within its ecosystem:
Governance: Token holders can participate in decision-making processes, such as adjusting protocol parameters or introducing new features.
Utility: Beyond governance, the token may be used for staking, rewarding participants, or providing incentives for liquidity providers, ensuring the protocol’s smooth operation.
Comparison with Luna
- Luna’s UST relied on a self-referential model, where Luna was burned to mint UST, leading to catastrophic devaluation during market stress.
- ENA avoids this by using a market-based approach where long and short positions balance each other, making it less susceptible to runaway feedback loops.
Risks in Bear Markets
- Low Market Activity: During downturns, demand for long positions declines, reducing funding fees for shorts.
- Sustainability: Without sufficient short incentives, the synthetic dollar could lose its peg, leading to instability.
ENA’s reliance on active market participation remains untested in prolonged bearish conditions. However, Ethena employs a robust risk management framework to ensure the stability of its synthetic asset, USDe. This includes strategies such as over-collateralization to mitigate liquidation risk, utilizing a delta-neutral approach to manage funding risk, and partnering with secure custodians for asset safety. Additionally, Ethena’s treasury backstop functions as a reserve fund to provide liquidity and support during market volatility, ensuring financial stability. These measures collectively strengthen the protocol’s resilience, protecting users from potential risks and market disruptions. It will be interesting to see how it performs during the next bear market.
Comparison: ENA vs. DAI (Maker)
Both ENA and Maker’s DAI represent synthetic asset models, but their mechanisms differ significantly:
Feature | USDe (ENA) | DAI (Maker) |
| Collateral Model | Long/short positions in perpetual markets. | Overcollateralized loans with crypto assets. |
| Stability Mechanism | Funding fees balance long and short positions. | Peg maintained via liquidation of collateral. |
| Bear Market Resilience | Vulnerable to low market activity and funding. | Stronger due to overcollateralization buffer. |
| Collateral Volatility | Relies on market activity for synthetic dollar. | Sensitive to collateral price fluctuations. |
| Adoption History | New and largely untested in bearish conditions. | Proven track record through multiple cycles. |
Historical Context for Maker
Maker has demonstrated resilience through multiple bear markets. By leveraging overcollateralization and robust risk management, the protocol has successfully maintained DAI’s stability even during extreme market volatility, highlighting its maturity and reliability.
Utility and Governance of the Maker Token (MKR)
The Maker token (MKR) plays a vital role in the DAI ecosystem:
- Governance: MKR holders vote on critical protocol decisions, such as adjusting collateralization ratios, introducing new collateral types, and setting stability fees.
- Utility: MKR acts as a backstop for the system. In case of under collateralization, new MKR tokens can be minted and sold to cover the deficit, ensuring the stability of DAI.
This dual functionality ensures that MKR holders are incentivized to maintain the protocol’s stability and efficiency.
Key Takeaways:
- ENA Strengths: Dynamic balancing of long and short positions introduces a new paradigm but is highly dependent on market activity.
- DAI Strengths: Overcollateralization and automated liquidations make it more robust in adverse market conditions.
Conclusion: Navigating DeFi Risks
The challenges faced by THORChain and Kujira, along with the experimental nature of synthetic asset models, underscore the vulnerabilities in DeFi. Diversifying collateral types, implementing robust governance, and preparing for bear markets are essential to ensure long-term sustainability.
Mitigation strategies such as building reserve funds, incentivizing liquidity, and introducing insurance mechanisms can help protocols navigate extreme conditions while maintaining user confidence.
As DeFi evolves, the lessons from RUNE, KUJI, ENA, and Maker demonstrate the need to balance innovation with risk management, paving the way for a more stable and mature ecosystem.
For a deeper dive into the strategies behind managing risk in decentralized finance, we invite you to explore our article on risk management for perpetual decentralized exchanges.