EU Commissioner calls for industry recommendations on DeFi regulation

European Commissioner Peter Kerstens called on the crypto industry to help come up with solutions on regulating decentralized finance, as the European Commission’s investigation in the matter gains momentum.  “If you want us to come up with great solutions come and talk to us,” the senior adviser to the Commission’s financial department and co-head of […]

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What directional liquidity pooling brings to DeFi

Directional liquidity pooling is a new way for liquidity providers to add liquidity to exchanges while avoiding impermanent loss.

Modern decentralized exchanges (DEXs) mainly rely on liquidity providers (LP) to provide the tokens that are being traded. These liquidity providers are rewarded by receiving a portion of the trading fees generated on the DEX. Unfortunately, while liquidity providers earn an income via fees, they’re exposed to impermanent loss if the price of their deposited assets changes.

Directional liquidity pooling is a new method that is different from the traditional system used by DEXs and aims to reduce the risk of impermanent loss for liquidity providers.

What is directional liquidity pooling?

Directional liquidity pooling is a system developed by Maverick automated market maker (AMM). The system lets liquidity providers control how their capital is used based on predicted price changes.

In the traditional liquidity pool model, liquidity providers are betting that the price of their asset pairs will move sideways. As long as the price of the asset pair doesn’t increase or decrease, the liquidity provider can collect fees without changing the ratio of their deposited tokens. However, if the price of any of the paired assets were to move up or down, the liquidity provider would lose money due to what is called impermanent loss. In some cases, these losses can be greater than the fees earned from the liquidity pool.

This is a major drawback of the traditional liquidity pool model since the liquidity provider cannot change their strategy to profit based on bullish or bearish price movements. So, for example, if a user expects Ether’s (ETH) price to increase, there is no method to earn profits via the liquidity pool system.

Directional liquidity pooling changes this system by allowing liquidity providers to choose a price direction and earn additional returns if they choose correctly. So, for example, if a user is bullish on ETH and the price increases, they’ll earn additional fees. Bob Baxley, chief technology officer of Maverick Protocol, told Cointelegraph:

“With directional LPing, LPs are no longer locked into the sideways market bet. Now they can make a bet with their LP position that the market will move in a certain direction. By bringing a new degree of freedom to liquidity providing, directional LPing AMMs like Maverick AMM open the liquidity pool market to a new class of LPs.”

How does this benefit users in DeFi?

The AMM industry and related technologies have grown quickly in the past few years. A very early innovation was UniSwap’s constant product (x * y = k) AMM. But, constant product AMMs are not capital efficient because each LP’s capital is spread over all values from zero to infinity, leaving only a small amount of liquidity at the current price.

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This means that even a small trade can have a big effect on the market price, causing the trader to lose money and the LP to pay less.

In order to solve this problem, several plans have been made to “concentrate liquidity” around a certain price. Curve made the Stableswap AMM, and all of the liquidity in the pool is centered around a single price, which is often equal to one. In the meantime, Uniswap v3 made the Range AMM more popular. This gives limited partners more control over where their liquidity goes by letting them stake a range of prices.

Range AMMs have given LPs a lot more freedom when it comes to allocating their cash. If the current price is included in the chosen range, capital efficiency may be much better than constant product AMMs. Of course, how much the stakes can go up depends on how much the LP can bet.

Because of the concentration of liquidity, LP capital is better at generating fees and swappers are getting much better pricing.

One big problem with range positions is their efficiency drops to zero if the price moves outside the range. So, to sum up, it’s possible that a “set it and forget it” liquidity pooling in Range AMM like Uniswap v3 could be even less efficient in the long run than a constant product LP position.

So, liquidity providers need to keep changing their range as the price moves to make a Range AMM work better. This takes work and technical knowledge to write contract integrations and gas fees.

Directional liquidity pooling lets liquidity providers stake a range and choose how the liquidity should move as the price moves. In addition, the AMM smart contract automatically changes liquidity with each swap, so liquidity providers can keep their money working no matter the price.

Liquidity providers can choose to have the automated market maker move their liquidity based on the price changes of their pooled assets. There are four different modes in total:

  • Static: Like traditional liquidity pools, the liquidity does not move.
  • Right: Liquidity moves right as the price increases and does not move as the price decreases (bullish expectation on price movement).
  • Left: Liquidity moves left as the price decreases and does not move as the price increases (bearish expectation on price movement).
  • Both: Liquidity moves in both price directions.

The liquidity provider can put up a single asset and have it move with the price. If the chosen direction matches the price performance of the asset, the liquidity provider can earn revenue from trading fees while avoiding impermanent loss.

When the price changes, impermanent loss happens because the AMM sells the more valuable asset in exchange for the less valuable asset, leaving the liquidity provider with a net loss.

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For example, if there is ETH and Token B (ERC-20 token) in the pool and ETH increases in price, the AMM will sell some ETH to buy more Token B. Baxley expanded on this:

“Directional liquidity represents a significant expansion of the options available to prospective LPs in decentralized finance. Current AMM positions are essentially a bet that the market will go sideways; if it doesn’t, an LP is likely to lose more in impermanent loss than they make in fees. This simple reality arguably keeps a lot of potential LPs from ever entering the market.”

When it comes to traditional AMMs, impermanent loss is difficult to hedge against since it can be caused by prices moving in any direction. On the other hand, directional liquidity providers can limit their exposure to impermanent loss with single-sided pooling. Single-sided pooling is where the liquidity provider only deposits one asset, so if impermanent loss happens, it can only occur on that single asset.

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3 reasons why DeFi investors should always look before leaping

DeFi investing is riddled with potholes. Here are a few tips on how to avoid them.

Welcome readers, and thanks for subscribing! The Altcoin Roundup newsletter is now authored by Cointelegraph’s resident newsletter writer Big Smokey. In the next few weeks, this newsletter will be renamed Crypto Market Musings, a weekly newsletter that provides ahead-of-the-curve analysis and tracks emerging trends in the crypto market. 

The publication date of the newsletter will remain the same, and the content will still place a heavy emphasis on the technical and fundamental analysis of cryptocurrencies from a more macro perspective in order to identify key shifts in investor sentiment and market structure. We hope you enjoy it!

DeFi has a problem, pump and dumps

When the bull market was in full swing, investing in decentralized finance (DeFi) tokens was like shooting fish in a barrel, but now that inflows to the sector pale in comparison to the market’s heyday, it’s much harder to identify good trades in the space.

During the DeFi summer, protocols were able to lure liquidity providers by offering three- to four-digit yields and mechanisms like liquid staking, lending via asset collateralization and token rewards for staking. The big issue was many of these reward offerings were unsustainable, and high emissions from some protocols led liquidity providers to auto-dump their rewards, creating constant sell pressure on a token’s price.

Total value locked (TVL) wars were another challenge faced by DeFi protocols, which had to constantly vie for investor capital in order to maintain the number of “users” willing to lock their funds within the protocol. This created a scenario where mercenary capital from whales and other cash-flush investors essentially airdropped funds to platforms offering the highest APY rewards for a short period of time, before eventually dumping rewards in the open market and shifting the investment funds to the greener pastures.

For platforms that secured series funding from venture capitalists, the same sort of activity took place. VCs pledge funds in exchange for tokens, and these entities reside in the ranks of the largest tokenholders in the most lucrative liquidity pools. The looming threat of token unlocks from early investors, high reward emissions and the steady auto-dumping of said rewards led to constant sell pressure and obviously stood in the way of any investor deciding to make a long investment based on fundamental analysis.

Combined, each of these scenarios created a vicious cycle where protocol TVL and the platform’s native token would basically launch, pump, dump and then slip into obscurity.

Rinse, wash, repeat.

So, how does one actually look beyond the candlestick chart to see if a DeFi platform is worth “investing” in?

Let’s take a look.

Is there revenue?

Here are two charts.

Algorand market capitalization vs. revenue (180 days). Source: Token Terminal
GMX market cap vs. revenue (180 days). Source: Token Terminal

Yes, one is going up and the other is going down (LOL). Of course, that’s the first thing investors look for, but there’s more. In the first chart, one will notice that Algorand (ALGO) has a $2.15-billion circulating market cap and a fully diluted market cap of $3.06 billion. Yet its 30-day revenue and annualized revenue are $7,690 and $93,600, respectively. Eye-raising, isn’t it?

Algorand protocol data. Source: Token Terminal

Circling back to the first chart, we can see that while maintaining a $2.15-billion circulating market cap and supporting a wide ecosystem of assorted decentralized applications (DApps), Algorand only managed to produce $336 in revenue on Oct. 19.

Unless there’s something wrong with the data or some metrics related to Algorand and its ecosystem are not captured by Token Terminal, this is shocking. Looking at the chart legend, one will also note that there are no token incentives or supply-side fees distributed to liquidity providers and token stakers.

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GMX, on the other hand, tells a different story. While maintaining a circulating market cap of $272 million and an annualized revenue of $28.92 million, GMX’s cumulative supply-side fees have steadily increased to the tune of $33.9 million since April 24, 2022. Supply-side fees represent the percentage of fees that go to service providers, including liquidity providers.

GMX cumulative supply side fees vs. revenue. Source: Token Terminal

Issuance and inflation

Before investing in a DeFi project, it’s wise to take a look at the token’s total supply, circulating supply, inflation rate and issuance rate. These metrics measure how many tokens are currently circulating in the market and the projected increase (issuance) of tokens in circulation. When it comes to DeFi tokens and altcoins, dilution is something that investors should be worried about, hence the allure of Bitcoin’s (BTC) supply cap and low inflation.

Bitcoin issuance and inflation data. Source: Messari

As shown below, compared to BTC, ALGO’s inflation rate and projected total supply are high. ALGO’s total supply is capped at 10 billion, with data showing 7 billion tokens in circulation today, but given the current revenue generated from fees and the amount shared with tokenholders, the supply cap and inflation rate don’t inspire much confidence.

Before taking up a position in ALGO, investors should look for more growth and daily active users of Algorand’s DApp ecosystem, and there obviously needs to be an uptick in fees and revenue.

ALGO issuance and inflation data. Source: Messari

Active addresses and daily active users

Whether revenues are high or low, two other important metrics to check are active addresses and daily active users if the data is available. Algorand has a multi-billion-dollar market cap and a 10-billion ALGO max supply, but low annual revenue and few token incentives present the question of whether the ecosystem’s growth is anemic.

Viewing the chart below, we can see that ALGO active addresses are rising, but generally, the growth is flat, and active address spikes appear to follow price surges and sell-offs. As of Oct. 14, there were 72,624 active addresses on Algorand.

ALGO active address count. Source: Messari

Like most DeFi protocols, the Polygon network has also seen a steady decline in daily active users and MATIC’s price. Data from CryptoQuant shows 2,714 active addresses, which pales in comparison to the 16,821 seen on May 17, 2021.

Polygon active address count. Source: CryptoQuant

Still, despite the decline, data from DappRadar shows a good deal of user activity and volume spread across various Polygon DApps.

Polygon DApps. Source: DappRadar

The same cannot be said for the DApps on Algorand.

Algorand DApps. Source: DappRadar

Right now, the crypto market is in a bear market, and this complicates trading for most investors. At the moment, investors should probably sit on their hands instead of taking kiss-and-a-prayer moon shots at every small breakout that turns out to be bull traps.

Investors might be better served by just sitting on their hands and tracking the data to see when new trends emerge, then looking deeper into the fundamentals that might back the sustainability of the new trend.

This newsletter was written by Big Smokey, the author of The Humble Pontificator Substack and resident newsletter author at Cointelegraph. Each Friday, Big Smokey will write market insights, trending how-tos, analyses and early-bird research on potential emerging trends within the crypto market.

The views and opinions expressed here are solely those of the author and do not necessarily reflect the views of Every investment and trading move involves risk, you should conduct your own research when making a decision.

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FBI issues alert over cybercriminal exploits targeting DeFi

FBI issues alert over cybercriminal exploits targeting DeFi

Smart contracts governing DeFi platforms identified as a particular cause for concern for the enforcement agency.

The U.S Federal Bureau of Investigation (FBI) has issued a fresh warning for investors in decentralized finance (DeFi) platforms, which have been targeted with $1.6 billion in exploits in 2022. 

In an Aug. 29 public service announcement on the FBI’s Internet Crime Complaint Center, the agency said the exploits have caused investors to lose money — advising investors to conduct diligent research about Defi platforms before using them, while also urging platforms to improve monitoring and conduct m rigorous code testing.

The law enforcement agency warned that cybercriminals are out in force to take advantage of “investors’ increased interest in cryptocurrencies,” and “the complexity of cross-chain functionality and open source nature of Defi platforms.”

The FBI observed cybercriminals exploiting vulnerabilities in smart contracts that govern DeFi platforms in order to steal investors’ cryptocurrency. 

In a specific example, the FBI mentioned cases where hackers used a “signature verification vulnerability” to plunder $321 million from the Wormhole token bridge back in February. It also mentioned a flash loan attack that was used to trigger an exploit in the Solana DeFi protocol Nirvana in July. 

However, that’s just a drop in a vast ocean; according to an analysis from blockchain security firm CertiK in M, since the start of the year, over $1.6 billion has been exploited from the DeFi space, surpassing the total amount stolen in 2020 and 2021 combined.

FBI recommends due diligence, testing

While the FBI admitted that “all investment involves some risk,” the agency has recommended that investors research DeFi platforms extensively before use, and when in doubt, seek advice from a licensed financial adviser.

The agency said it was also very important that the platform’s protocols are sound, and to ensure they have had one or more code audits performed by independent auditors.

Typically, a code audit involves a review of the platforms underlying code to identify vulnerabilities or weaknesses which could be exploited.

According to the FBI, any DeFi investment pools with an “extremely limited timeframe to join” or “rapid deployment of smart contracts” should also be approached with extreme caution, especially if they have not conducted a code audit.

Crowdsourced solutions, generating ideas or content by soliciting contributions from a large group of people, were also flagged by the law enforcement agency. 

“Open source code repositories allow unfettered access to all individuals, to include those with nefarious intentions.”

The FBI said DeFi platforms can also do their part to increase security by testing their code regularly to identify vulnerabilities, along with real-time analytics and monitoring.

An incident response plan and informing users about possible platform vulnerabilities, hacks, exploits, or other suspicious activity are also among the recommendations.

However, failing all that, the FBI urges American investors targeted by hackers to contact them through the Internet Crime Complaint Center or their local FBI field office.

Related: FBI issues public warning over fake crypto apps

Earlier this year, U.S. Deputy Attorney General Lisa Monaco announced the FBI was stepping up its efforts to address crime in the digital asset space with the formation of the Virtual Asset Exploitation Unit.

The specialized team is dedicated to cryptocurrency and includes experts to help with blockchain analysis as part of a shift in focus toward disruption of international criminal networks, rather than just their prosecution.

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Tornado Cash shows that DeFi can’t escape regulation

Tornado Cash shows that DeFi can’t escape regulation

DeFi developers seriously need to consider working with regulators on compliance issues if they want their projects to succeed.

The U.S. Treasury’s Office of Foreign Assets Control (OFAC) issued sanctions against Tornado Cash this month, marking its first action against a decentralized finance (DeFi) mixer in what may prove to be a watershed moment for DeFi regulation.

A lack of response and regulatory preparation from the industry is perhaps unsurprising of a mindset honed outside the rule of law. Yet, the potential of DeFi is threatened if its leaders do not face the reality that regulation in this space will only increase. Taking steps to work with regulators is now the only way forward.

On Aug. 8, OFAC targeted Tornado Cash for processing transactions totaling more than $1.5 billion on behalf of illicit actors, including North Korean cybercriminals. The consequences of the action are severe: US individuals and companies, including crypto exchanges and financial institutions, are now prohibited from transacting with Tornado Cash addresses.

This will hinder criminals’ ability to launder funds through the service, which has become a prolific part of the cybercrime ecosystem. However, OFAC’s action against Tornado Cash sends a clear message to everyone in the space: DeFi is now firmly in regulators’ crosshairs and won’t escape regulation.

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History tells us it is inevitable now that regulatory scrutiny will only accelerate. Prevailing “DeFi think” is a tendency to ignore or brush this fact under the carpet, but a rethink is needed. Regulators’ motives are not malevolent. They are simply toeing the very fine line of suppressing crime without neutering the positive potential of DeFi.

To evidence this, a Financial Action Task Force (FATF) report published earlier this year noted that cross-chain bridges are facilitating the growth of DeFi, but are also enabling criminals to swap funds more swiftly, generating money laundering risks. The negative focus is on the crime — not the technology or its potential.

DeFi developers and those participating in the ecosystem will seriously need to consider working with regulators on compliance issues if they want their projects to succeed.

Concerningly, the reaction of many DeFi developers and others in the ecosystem has been to shrug and argue that DeFi is, by nature, unregulatable. Because regulation involves imposing rules on centralized intermediaries, the argument runs, regulating DeFi is not possible. Consequently, many DeFi projects have not attempted to comply because they believe they are safely beyond regulators’ reach.

For some, the hope of a convincing facade of regulatory compliance has been comforting enough. But Tornado Cash renders this unrealistic. The mixer repeatedly claimed to be complying with OFAC sanctions; however, the U.S. Treasury indicated in its statement on Tornado Cash that it “repeatedly failed to impose effective controls designed to stop it from laundering funds for malicious cyber actors on a regular basis and without basic measures to address its risks.” Window dressing will no longer suffice. Thorough compliance protocols are now a requirement.

Fortunately, some within the industry are alive to this reality, and there are a handful of DeFi projects that have begun to implement compliance controls in anticipation of regulation. However, this kind of preparation is far from widespread which is a worry for anyone hoping to see a competitive DeFi ecosystem in the future.

The specter of institutionalization perhaps presents an explanation for the lack of alignment between regulators and the industry. DeFi’s beginnings are defiant and off-grid, whereas regulators’ recent attention to the space suggests that they and their bedfellows in big finance and investment industries spy an opportunity.

Such is their interest: the integration of DeFi into the mainstream is now inevitable. Heavily regulated institutions see compliance as a precondition for participating in the DeFi space, and will avoid fully embracing the space until they’re confident it is compatible with regulation.

Investors are also sensitive to frameworks that mitigate reputational damage and protect them against risks. No investor will want to sink their money into a DeFi project that winds up blocklisted for facilitating activity with the likes of North Korea. Within this paradigm, DeFi initiatives that are unresponsive to these regulatory concerns have a fast deteriorating shelf-life.

The Tornado Cash saga has shown that the costs of failing to factor regulation into DeFi development are now too great to ignore. Compliance activities inevitably come with costs too, but as the institutionalization of DeFi looks increasingly inevitable, it is those who actively look to embrace regulatory compliance as they build out the DeFi ecosystem that will tread the path to growth as others fall to the wayside.

This article is for general information purposes and is not intended to be and should not be taken as legal or investment advice. The opinions expressed are the author’s alone and do not necessarily reflect the views of Cointelegraph. 

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