As DeFi Liquidity Crisis Looms Following Bancor’s IPL Freeze, CVI Offers a Solution

By June 23, 2022DeFi
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The prominent DeFi protocol Bancor this week announced that it’s suspending its recently launched Impermanent Loss Protection scheme amid a massive plunge in value of its native Bancor Network Token BNT, -0.14%.

Citing both hostile market conditions and market manipulation, Bancor insisted the measure is only temporary and noted that all funds on its protocol are secure. Trading remains active on all of its liquidity pools, it added.

The move highlights how the DeFi industry appears to be on the verge of a liquidity crisis amid a months-long selloff in crypto that has shown no signs of ending. As cryptocurrency token prices have plunged, many investors have withdrawn their funds from liquidity pools to move into safer assets.

That has had a negative impact on many DeFi protocols as they rely on having fat liquidity pools to be able to operate. Token holders are incentivized to place their assets in liquidity pools with the promise of earning transaction fees in return for lending their capital. However, while this can be profitable, liquidity providers can still be at risk of impermanent loss, which is when the value of their staked assets changes relative to the initial value when they were first deposited.

To offer some protection against this and provide more incentive to liquidity providers, Bancor launched its IL protection mechanism earlier this year, positioning it as a special feature that sets it apart from other DeFi protocols.

However, Bancor is now disabling that special feature in a move it said is designed to “protect the protocol and its users from potentially manipulative actors”, and has promised to re-enable it at a later date, once the market stabilizes again. However, it gave no specific timeline as to when this might happen.

While Bancor insists its protocol is otherwise working normally, saying that users can continue to receive yields on their staked assets, the fact is that it’s in a very precarious position. The abrupt decision to cancel IL protection follows a spectacular dump that has seen BNT’s value fall by 95% from its all-time high in 2021, to just $0.53 per token.

The IL protection feature is partly to blame for this decline. That’s because Bancor’s IL compensation has the effect of increasing the supply of BNT, diluting its value. The situation has been exacerbated by what Bancor said was “the recent insolvency of two large centralized entities who were key beneficiaries of BNT liquidity mining rewards”, it added. It explained that these entities have rapidly liquidated their BNT holdings and withdrawn large sums of liquidity from its protocol. Adding to these problems, an “unknown entity” has also opened a large short position against BNT on an external exchange, Bancor said.

The dodgy tokenomics of Bancor’s IL protection insurance were attacked by rival DeFi Platform CVI, which pointed out in a Twitter thread that it mints and burns BNT to try and achieve a balance, similar in many ways to how Terra attempted to balance TerraUSD and LUNA. The problem with this mechanism, CVI said, is that runaway events can quickly get out of control.

Bancor’s decision was timely for CVI, which has only recently launched its own IL protection. CVI claims it employs a very different mechanism that provides a much better balance between buyers and sellers of protection, ensuring there’s no need to fight over limited liquidity pools. Further, CVI said its mechanism has the benefit of zero counterparty risk for protection buyers, cross-chain protection, automated payouts and very high capital efficiency.

Right now, DeFi appears to be on the verge of a severe liquidity crisis, with DeFi lender Celsius last week announcing it has temporarily paused withdrawals due to the pressure of lack of liquidity. In the last few days, it has been joined in a withdrawal freeze by Babel Finance.

CVI’s claims to ensure a proper balance could well be tested in the coming weeks if the crypto market sees further declines, as many have predicted. With any luck, it will be able to weather the storm and give investors a much-needed reason to consider reinvesting in a DeFi world that’s desperately in need of both greater liquidity and the confidence that will bring.

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