In todays globalized world, centralized web2 players take an ever more important part in our lives. By using the data their users give away eagerly and with consent, they are able to influence which news we read online, which content we consume, which ads trick us into buying things we don’t really need and many other business models. The vision of a decentralized web3 challenges business models of data-driven internet giants. It aims to give back data ownership to individual users. Unfortunately, decentralization in itself does not only bring benefits to users. It also comes with a whole new set of challenges, risks and attack angles.

Exploiting a concept.

Decentralization is occasionally being used as a keyword or concept to cover up projects embedded within a global grey zone of anonymous “DAOs” that are trying to evade any form of legal responsibility for damaging and self-enriching behaviour, or to straight up exploit the lack of legislation to set up and commit fraud. Rug Pulls and deliberately installed backdoors to exploit, hack and steal users assets are unfortunately not an isolated instance in the world of crypto assets.

One of the most famous and blunt cases was the (claimed to be) “decentralized and trustless network” Squid Game Token. Claiming to be part of a bigger soon to be launched blockchain gaming application, it created an immense wave of hype. Even mainstream media fired it up, and eventually it ended up as a massive rug pull when user noticed there was no way to exit from the project and all of a sudden the liquidity pools were drained. But how can such a disaster happen with a “decentralized” and “DAO governed” project?

What is “Decentralization”?

The three main pillars of blockchain technology are immutability, transparency, and decentralization. Even though all of them are in the end equally important to the concept, the decentralization pillar is often misunderstood. Digital assets tend to be (if we count out certain outliers such as Tether or very early stage projects) decentralized. That simply means that a certain number of validators draw a blockchain consensus. That effectively eliminates “centralized” counterparty risk and exploitation by this centralized entity.

Despite most commonly known digital assets formally being decentralized, there are big differences in their level of decentralization. Decentralized Autonomous Organisations (DAOs) serve as a backbone for the decentralized economy. They receive a lot of attention in the sphere of decentralization and decentralized governance. Decentralized Autonomous Organisations have formed more or less naturally and gained attention as a response to very high counterparty risk in the poorly regulated and supervised digital asset ecosystem. A good example of counterparty risk that has caused a sizeable financial woe to investors is the recent case of FTX. In this case customer assets were either gambled away or seized in bankruptcy proceedings.

What the concept of DAO is trying to do differently is that it allows full transparency over the whole project. That includes treasury of foundations, staked assets, assets bonded in smart contracts, and self-custodianship over personal assets. You can interact with open and transparent protocols. You can also commit to changing and improving the product. However, the private keys remain under your control.

Centralization risk of Decentralized Autonomous Organizations

Even though DAOs are here to reduce counter-party risk and create trustless networks managed by an open and transparent governing body, sadly cases like Squid Game Token are still happening due to their close connection with the projects and the lack of decentralization at their core. Decentralized Autonomous Organizations function on a basis of vote proposals and voting to apply changes on the blockchain. The more assets an individual has staked, the more votes the individual has. As DAO functions on the Proof of Stake mechanism. One or a few stakeholders can highly centralize the voting power by making the whole protocol centralized in its core.

In case DAO governs the protocol, but de facto has highly centralized voting power on a single entity, the entity can run changes however they see fit. Liquidity pools can be drained, rewards can be locked, and tokenomics proposals can be rigged in the favor of the controlling group.

Not every ‘relatively centralized’ DAO intends to engage in fraudulent behavior

The main problem with a high level of decentralization is, besides the fragmented thus slower network, the cost to run the network. Decentralization requires a higher number of validators. They will need a financial incentive to run the hardware, as well as stake themselves or in delegated PoS attract (aka share financial incentives with) a significant sum of assets to become qualified validators. The cost is a primary reason why a lot of projects opt for a more centralized type of governance until the project gains sufficient traction and becomes self-sustaining with a larger number of validators. Once the project has sufficient traction and revenue generation, it is financially feasible to keep the high number of validators content and committed to the project.

The best alpha potential lies with early-stage projects. These projects tend to be more centralized due to limitations in sharing financial incentives with many validators. Therefore, filtering out good and harmful projects is crucial.

In the beginning of the project, high level decentralisation allows the team to fix the issues and add features far faster than it would otherwise while operating much leaner. But there is always this risk of things going in the wrong direction. The path between an “efficient” early stage, and centralization being too high of a risk can be very narrow.

The way one can reduce this specific potential risks is to perform a strict due diligence process. This process consists of deep research of numerous parts of the project. KYC of the team behind the project, genesis token supply distribution, governance functionality design, decentralization ramp up roadmap, tokenomics proposals, governance proposals, initial asset distribution plan, and many more. Anybody carrying out this type of DD could have easily avoided falling into a trap such as Squid Game Token.

Do you want to know more about our internal approach to research and how the fund operates and analyze? Hit us up!

Author: David Teufel

Our analyst and fund management team of Tigris Web3 – Austrian Crypto Fund, managed by Venionaire Investment GmbH – are currently monitoring the market situation. They are of course evaluating possible scenarios for following developments. Most important for our investors and clients, Tigris Web3 has had zero exposure in stablecoins, and no exposure to Silvergate or Silicon Valley Bank. The funds strategy is to reduce counter party risk through usage and investment in decentralized projects. This excludes the investment or cooperation with centralized entities like crypto banks, stablecoin issuers and centralised exchanges. The following article gives a wrap up and analytical interpretation of how the current situation might unfold.

What happened so far?

On the 10th of March, the 18th largest US bank by nominal deposit amount, Silicon Valley Bank, has become insolvent. Thus it ended up in FDIC receivership.

The bank became insolvent due to the inherent nature of the current banking system – the fractional reserve system. A fractional reserve system allows banks to not have full treasury backing, but can mark-to-market their reserves, which in the case of a bank run, makes the bank insolvent. Essentially and summed up to the highest level, this is what SVB faced in the second week of march.

Spillover into crypto markets

The insolvency of the bank has heavily hit Circle, the company behind the 2nd biggest stablecoin, USDC. USDC, which is fully backed by US Dollar, had 3.3 billion USD worth of collateral on the accounts of the bank. Even though 3.3 billion USD is shy of 8% of the total market capitalization of USDC, the price of the stablecoin, which is supposed to be as the name indicate – stable at 1 USD, started dropping overnight. The insolvency and liquidation of Silvergate earlier this week, a bank heavily involved in crypto markets, who was also a partner of Circle, is adding fuel to the fire.

Figure 1. USDC Market cap (1D Chart) source: coinmarketcap.com

The potential amounts lost on Silvergate are currently unknown. This led to the beginning of a bank run on USDC, with lots of crypto market participants swapping into other stablecoins, large cap crypto currencies or Fiat USD. Naturally, this caused the USDC depeg which at this time is larger than the estimated (potential) gap of collateral caused by the Silicon Valley Bank insolvency.

Another stablecoin project, DAI, has also disconnected in the wake of the scandal. Even though DAI had no exposure to the bank directly, 50% of DAI reserves are backed by USDC as collateral.

Systemic TradFi risks in crypto markets

The irony of this case lies in the fact that theoretically flaws of the traditional finance economy rarely affect crypto projects, as one of their inherent ideological pillar is to create a better, fairer and more resistant system. This case is unique though. The cause of the drop is a systematic counter-party risk. There is no inherent crypto market flaw or fraud at play. One can not blame Circle, as Circle is the most transparent and audited-on-point stable-currency provider. Even Silicon Valley Bank itself can at this point and with the information available so far not been held fully responsible either. Bank runs can happen. In this cause triggered through supposedly poor communication and unlucky timing. Even though their reserves were as conservative as possible, they still tumbled into insolvency due to fractional reserve policy installed by the FED.

Regulatory repercussions

One likely outcome is an even tighter and stronger accelerated approach to the regulation of stablecoins by financial market authorities and central banks – with the ultimate peak of this process being the eventual issuance of CBDCs. Although not very likely, we might even see the FED stepping in in some way in the next days, potentially even taking control of Circle. The meltdown of Luna and UST, and most recently the collapse and alleged fraudulent nature of FTX already previously enforced this step from a regulator’s point of view. Many crypto market participants see this very sceptical due to ideological resons. But increased regulatory security with fully regulated and safe stablecoins creating the ultimate smooth Fiat on- and offramp and DeFi backbone could be one of the necessary triggers for broad adoption of the technology.

Tigris Web3 analysis

Situations like the one with Silicon Valley Bank and Circle enforce our view for the need for decentralized and fully transparent solutions which mitigate counterparty risk. That is one of the main pillars in the investment thesis behind Tigris Web3, a Web3 focused fund managed by Venionaire Investment. Overall we see very low systemic risk at this point for both the portfolio assets and broader thesis of the fund. Circle hast very strong institutional backing. There is too much at stake (both financially and in trustworthiness) compared to what the actual financial damage through the insolvency of Silicon Valley Bank might be. Tigris Web3 is neither invested in USDC, DAI or any other stable coin. Also, we have no funds or accounts with Silicon Valley Bank or Silvergate. If you want to learn more about Tigris Web3, our portfolio assets and projects and investment thesis reach out to david@venionaire.com

Disclaimer

As this situation is currently unfolding, the parties involved are releasing new data and insights on an ongoing basis. This article only reflects the interpretation and knowledge based on information available until 11^th March 2023, 10:30am CET. This is no financial advice. Investing in crypto assets is of the highest risk and can lead to a total loss of funds invested.

Authors: David Teufel & Ivo Pernar