Would you believe it if I told you that in the past few years, multiple fashion designers around the world have raised millions of dollars to sell clothes that do not exist? Or that an upstart fashion brand, RTFKT, sold 600 pairs of “phygital” NFT shoes for more than three million US dollars in under seven minutes and was subsequently acquired by Nike last year? What are the investors and purchasers of digital fashion and phygitals thinking; are they crazy? NYALA says: Absolutely not!
This article is intended to explain what digital fashion and phygitals are, the enormous business opportunity that they represent, and how NYALA can help you launch your digital fashion brand in the metaverse. If you are a fashion designer and/or manufacturer that is interested in being early to the lucrative future of fashion, contact William at w.bailey@nyala.de to start a discussion.
Fewocious x RTFKT Phygital Shoes
Before moving further, let’s take the time to define what digital fashion and phygitals are. To do that, we first need to talk about the ‘metaverse’, which I will define as persistent digital spaces where people socialize, work, and play. In a way, thanks to social media and smartphones, a large portion of the global population already spends most of their waking hours in a rudimentary form of the metaverse. Advances in augmented and virtual reality technology are pushing us towards a more immersive and engulfing metaverse experience that our senses will increasingly be unable to differentiate from reality. As the technology continues to improve, the call of a simulated reality will be increasingly difficult to resist and more people will spend more of their life in virtual worlds than in physical reality. As people invest more time and energy into their digital identity, they will also place greater importance on social signaling to their peers in the metaverse.
Mockup of next-generation Google Glasses
This leads to the demand for digital fashion, which will be worn by the digital avatars people use. If you want to impress clients and friends in the metaverse, you are unlikely to present yourself with a hideous avatar. Instead, you will want to display that you have the means to dress your avatar in ways that others cannot afford or access. In short, digital fashion is fashion created specifically to be worn by the avatars that people use in the metaverse. Big companies like Meta envision this kind of future, which is why they are already selling digital fashion items from companies like Balenciaga and Prada in their “Avatars Store”.
Digital Balenciaga clothing that can be purchased in the Meta Avatars Store
At this point, you may ask yourself, how can something purely digital be valuable if anyone can make infinite copies of it? The answer is blockchain technology, which makes scarcity possible in a digital context; cryptocurrency is the monetary expression of this breakthrough and NFTs are the medium by which individuals can “own” anything else in digital form, including digital fashion. Furthermore, as the boundaries between physical reality and the digital world continue to melt, more and more consumers will demand that the items they buy can be owned and used in both the metaverse and the physical world. “Phygitals”, physical items with embedded tracking devices that link them to a non-fungible token (“NFT”) registered on a blockchain are now also becoming increasingly common. Existing fashion brands have taken notice and today, it is hard to find a major Western clothing brand that does not have some kind of digital fashion and phygitals strategy. In fact, LVMH, the Prada Group, Cartier, and other luxury brands have cooperated to create their own blockchain, named “Aura”, and are already using it to issue NFT-linked certificates of authenticity with their products.
NFT-linked certificate of authenticity now provided with Prada goods
The next question many have is, who would buy this stuff? The target consumer base for digital fashion and phygitals is still narrow but its constituents are, on average, young, wealthy, and always online. Hype beasts, professional gamers, and cryptocurrency “degens” are three of the most influential Internet-native communities that have developed in the past decade. Their ranks grow at an increasing rate with each passing year, as the percentage of humans that are always online increases globally.
The hype beast spends lavishly on “drip”, intentionally overpriced clothing and accessories with limited supply that often look absurd to outsiders, in order to “flex” on their peers and gain their admiration.
The gamer needs to be able to afford the latest and greatest gaming hardware to maintain their competitive edge and invests in “skins” for their avatars to show off to their peers.
The cryptocurrency degen has benefitted from the meteoric rise of the most profitable asset class in modern history and, despite the recent market downturn, still has plenty of capital to deploy into new forms of speculation while waiting for cryptocurrency prices to rebound.
Of all the possible products that can be marketed to these three groups, digital fashion and phygitals have found the earliest market fit due to the ubiquitous use of avatars in the metaverse. The savvy entrepreneur doing market research will notice some important traits shared by all three groups; they are, on average, flush with cash and eager to spend it on status items that impress their peers. However, what they consider to be a status item is generally very different from what the “normies” outside of their circles deem valuable. The implications of this are that established luxury brands need to work harder than usual to capture their attention and start-up fashion houses have a greater chance at capturing early market share if they can understand their tastes. The fledgling fashion houses that targeted these groups early on, like RTFKT and The Fabricant, have been extremely successful.
Augmented reality clothing designed by The Fabricant
So, what value is created by digital fashion and phygitals beyond showing off to your friends, family, and colleagues? Actually, quite a bit!
Phygitals combat counterfeiting and foster the development of healthy secondary markets, which encourages circular use of clothing rather than them being thrown away. While it remains trivial to counterfeit physical aspects of a phygital, it is not possible to counterfeit the embedded chip linked to an NFT on a blockchain. The chip can be scanned with any modern smartphone and verified as authentic by anyone on the spot. Linking physical items to NFTs makes counterfeiting more difficult, which enables more robust secondary markets to trade them because of increased trust in their authenticity. Consumers are then more willing to purchase expensive items because they are confident that they can resell them without issues, which also encourages more reuse of items. The original manufacturer can also benefit from automatic royalties earned on secondary market sales if they choose to include royalties in the smart contract. Luxury brands stand to benefit the most from the utility brought by phygitals due to the higher price point, rate of counterfeiting, and collectability of their products, which explains their speed in adopting NFT technology relative to other industries and segments of the fashion industry.
Blockchain smart contracts also increase capital efficiency. The owner can lend out digital fashion items in a trustless manner to earn yield on them when they are not using them, making it easier to market expensive purchases to consumers as investments. It also turns the fundraising model for fashion on its head: start-ups can raise money from the public through “Initial Fashion Offering” token sales and NFT sales, then use the proceeds to invest in the means of production to create phygital items and physical storefronts. These token investors and NFT purchasers are incentivized to independently evangelize and market your brand for you, as they are financially invested in your success. This dramatically reduces the need for and may be more effective marketing than budgeting for a traditional marketing agency.
Smart contract technology allows for interesting new product features, such as items that “evolve” in response to different digital or physical world stimuli. Nike CryptoKicks, for example, change appearance based off which “skin vial” is applied to them. This is the pinnacle of customization, deeply interesting to younger consumers. It also enables use cases that highlight group membership in interesting new ways, such as exclusive events that can only be attended by owners of the correct phygital items that are scanned at the door. Augmented reality technology can be leveraged such that only other owners of the same phygital item can see certain details and animations attached to your clothing as you walk by each other on the street. Nike’s augmented reality hoodie is a recent example of this concept.
The eight different „DNA“ designs of Nike CryptoKicks phygital shoes
Nike x RTFKT’s augmented reality hoodie
Digital fashion is environmentally friendly because it aims to supplant some of the demand for physical clothing, especially “fast fashion”. Survey after survey finds that a shocking percentage of the population in developed countries admit to wearing items of clothing once before throwing them away. Social media largely drives this trend, as users will buy items of clothing to wear in one photo before throwing them away or returning them. The Ellen MacArthur Foundation estimates that the fashion industry generates roughly 10 percent of global CO2 emissions, more than all international flights and shipping combined. Digital fashion is an ideal solution to the fast fashion problem: social media users can superimpose items of clothing on themselves using augmented reality technology. The same photo and likes from followers are generated, without the pollution.
Digital fashion items have many advantages that will drive their rapid adoption but, in addition to their intrinsic benefits, the environment where they exist, the metaverse, is infinite and unbounded by the laws of physics. This opens up a huge amount of retail space that did not exist before and allows for the creation of items that are impractical and/or impossible to create in the physical world. It also eliminates the cost of opening and maintaining a physical retail space, which puts start-ups on a more even footing with retail giants.
NikeLand, Nike’s metaverse store in the Roblox video game
The field of digital fashion and phygitals is still wide open for the visionary and ambitious to capitalize on. The permissionless nature of public blockchains is empowering a new wave of young designers to launch digital fashion brands and raise money to fund their vision in ways that were not previously possible.
NYALA wants to collaborate with European fashion designers and manufacturers to bring a new wave of digital fashion and phygital brands to market. We will provide our market knowledge, German-regulated tokenization services, and simple custodial services needed to safely bring your brand into the metaverse. As needed, we can also help with things like marketing, fundraising, tokenomics design, and NFT brand strategy. If this proposal interests you, please contact William at w.bailey@nyala.com for more details.
Over the coming months, NYALA will publish more articles covering the burgeoning digital fashion and phygital industries from several different aspects. We will examine the technology and product strategies being used by start-ups and incumbents today and how they might change in the future. The goal is to provide the reader with a comprehensive overview of what is happening, where the market is going, and actionable insights that start-ups working with us can leverage for fast growth. We look forward to building this part of the future with you!
He is right; how could the merge already be priced in if most market participants have only a vague understanding of what it is? This post is intended to quickly bring you up to speed on what the Ethereum merge is and the different scenarios that might arise in its aftermath.
As this is a lengthier post, it will be divided into four sections for clarity.
I Rebellion of the miners
II DeFi shadow economy
III Trader’s delight
IV OFAC, we are in danger!
Before diving into details, here are the basics you need to know:
I Rebellion of the miners
From the point of view of existing Ethereum miners, the switch to PoS is a disaster. They lose their raison d’etre and source of income as a result of the merge. The miners being deprecated have nearly every incentive to push for a contentious hard fork, engineering a final profit opportunity that they are likely to milk for the coming years.
A contentious fork of a blockchain occurs when there is too much disagreement over a change being made and the blockchain “forks off” into multiple independent blockchains that conform to the desires of the different camps. Each forked blockchain has its own version of the original token, so the holder of a single pre-fork token will be able to claim and spend multiple forked tokens. In defiance of logic and traditional economic thought, the combined market capitalization of the forked tokens often exceeds the market capitalization lost by the original chain being forked.
The “last stand” mentality of Ethereum miners with nothing to lose is likely to result in popcorn-worthy outcomes during the merge. Insider information and coordination can make forks extremely profitable events for instigators that can control events and are looking at their last chance to cash out. Chandler Guo, an influential figure in the Chinese Ethereum mining community and important driver of the Ethereum Classic fork, is promising to fork Ethereum again.
II DeFi shadow economy
Another reason to expect drama is Ethereum’s massive size. We simply have never seen a $200bn+ USD market capitalization blockchain hosting thousands of smart contracts that collectively control ~$40bn USD in assets undergo a contentious hard fork. History and futures markets tell us that the ETHPoW forks will have a market capitalization of at least a few billion USD but what will happen to the DeFi economy on them? Circle and Tether have already announced that only USDC and USDT stablecoins on the PoS chain will be valid but smaller DeFi and stablecoin projects may deviate by not moving over or retaining unexpectedly high residual value on the PoW forks.
If ETHPoW tokens have value, then maybe CRV tokens on ETHPoW still have value too. This means that liquidity provision could still be incentivized and Curve liquidity pools could continue to function on ETHPoW. Even if Chainlink oracles will not function on the PoW chains, other types of oracles will and can suffice for most purposes in the beginning. Will we see parallel DeFi economies running on ETHPoW forks? It’s likely.
Now that certain NFTs cost more than luxury real estate, it is also worth thinking about whether an NFT on a PoW chain could have any value. If the NFT points to the same IPFS link from every fork, which is the real NFT? In light of questions like this, it is safe to say that copies of NFTs on forked ETHPoW chains will have some value and we should expect to see marketplaces pop up for holders to sell their “knockoff” NFTs on ETHPoW forks.
III Trader’s delight
So how exactly can one benefit from these forks? You must be holding spot Ethereum at an address to which you control the private keys. If you leave your Ethereum on an exchange or with some other custody provider, there is no guarantee that they will credit you the forked tokens. Once the fork occurs, you will need to find a reliable wallet provider that supports the forked token and import your account there, before sending the forked token to an exchange or elsewhere.
Those who are a little bit more sophisticated could consider holding spot Ethereum to collect the forked tokens but hedge their price exposure by selling short the equivalent amount of ETH futures contracts or stETH tokens. Exchanges like Poloniex and BitMex already offer trading of ETHPoW futures contracts, so one can already see the market’s estimate of the fork’s value before deciding whether to pursue a strategy.
Another strategy to consider is borrowing ETH with stablecoins such as USDC and USDT with a DeFi protocol on Ethereum, such as Aave. On any PoW fork on which the ETHPoW token has value and DeFi protocols are operational, you will be able to sell your ETHPoW tokens for a profit and possibly repay your version of the loan on that chain with worthless stablecoins at essentially no cost. This is a much more complicated strategy that is dependent on timing; we should expect to see on-chain ETH borrowing to spike shortly before the merge is supposed to occur for this reason.
This is not financial advice, do your own research and consult your financial advisor before making any financial decisions.
IV OFAC, we are in danger!
The potential issues that could arise from the merge do not stop when the merge is completed in September. The Ethereum Beacon Chain was launched in Dec 2020 with the intent to test Ethereum PoS consensus in production and accumulate sufficient staked ETH to secure the chain. At the time of this writing, there are more than four hundred thousand validators active on the beacon chain but this number is misleading because each validator’s stake is capped at 32 ETH. This means that someone who wants to stake 320 ETH will need to create ten validators. The validator count statistic thus does not inform us how many actual entities amongst the validator set, nor how their stakes are distributed.
When we look at the data with other tools, we can see that validator concentration is actually quite high. Lido, a decentralized liquid staking protocol, controls around 30% of staked ETH and Coinbase + Kraken + Binance control another combined 30%. The risk of collusion is elevated.
This concentration of the validator set is particularly concerning in light of the US Treasury Department placing the mixer, Tornado Cash, on the OFAC sanctions list recently. Tornado Cash is a tool used to obfuscate the origin of assets sent on the Ethereum network. To comply with American regulation, cryptocurrency companies and applications must not allow American users to interact with individuals and entities on the OFAC sanctions list. The reaction by most cryptocurrency apps and companies in cutting off Tornado Cash and addresses linked to it was blunt and swift.
Some apps and companies even went overboard with enforcement. An activist and/or prankster sent 0.1 ETH tainted by interaction with Tornado Cash to many prominent members of the crypto community with known addresses. The recipients soon found that they were blocked by the Aave front-end from interaction with their loan position due to an update that the Aave team quickly shipped to their front end. After complaints, this blanket enforcement measure was temporarily rolled back.
These events make it clear that Ethereum is at a heightened risk of regulatory capture in this tender moment of its evolution. If regulators demand that Ethereum PoS validators do not include transactions linked to OFAC-sanctioned addresses in blocks that they validate and the majority of staked ETH is controlled by staking pool operators with significant US business exposure, as it is today, the expectation is that they will comply and the dissenting validators will be unable to effectively resist.
An OFAC-compliant Ethereum would be received as a hostile takeover by most of the crypto community and would certainly lead to an additional fork, a second PoS Ethereum chain that would claim to be credibly neutral by refusing to censor transactions. The most pragmatic long term solution would be to try and diversify the validator set with an influx of new, independent participants before this scenario materializes but the convenience offered by staking pool providers makes concentration of tokens into their control seem impossible to overcome.
Another option is slashing. Ethereum’s current PoW consensus does not make it immune to demands by regulators to censor certain transactions, but it at least is not possible to seize the tokens of others for not doing so. In Ethereum’s PoS version, validators can lose their staked tokens for acting against the rules or interests of the network. This act of seizing the tokens is called slashing. Slashing can also be initiated via social consensus; both sides of this hypothetical battle are likely to use slashing as a threat or weapon against the other side to try and win. The Ethereum community has repeatedly asserted that it could coordinate a social recovery of the network in such scenarios by invoking slashing of the transaction-censoring validators‘ tokens through social consensus.
There is so much built up expectation and capital riding on the upcoming Ethereum merge that it is likely to be a source of drama for the rest of the year in the crypto community. After multiple successful merges on Ethereum testnets, the Ethereum community generally has faith that the merge will be smooth and turn ETH into a deflationary, ESG-friendly, yield-bearing asset that institutions will invest in heavily. On the other hand, many traders see a messy merge as likely and are positioning themselves to profit accordingly. These viewpoints cannot be reconciled easily; who will be right? The best heuristic of what will happen in crypto is to imagine what the most absurd outcome would be. I leave it to the reader to imagine these scenarios, confident that no matter what you think of, you will be surprised by the events of the Ethereum merge in September.
Good luck to all who partake!
[1] https://twitter.com/Blockworks_/status/1552581167550963712
[2] https://docs.ethhub.io/ethereum-basics/monetary-policy/
It is not suddenly less safe to use Solana despite the recent bad press it has received. This blog post will explain why.
Humans have always had a predilection for symbology; the most ancient symbols could be described as the earliest memes. Cryptocurrency markets richly reward those who can predict which symbols and memes will be popular and when. There are many millionaires walking this planet today whose life changing investment thesis was “dog coins good”, executed at an opportune moment. Symbols of the sun and the moon have always been popular, so it was probably inevitable that a sun coin (Solana) and a moon coin (Luna) rose in the market capitalization ranks so quickly.
More seriously, Solana is a blockchain that emphasizes transaction throughput above everything else. Due to its fast transaction confirmations and cheap transaction fees, it has attracted one of the larger user bases amongst major blockchains. With the implicit and explicit backing of FTX Exchange, Alameda Research, and Jump Crypto, Solana was even able to negotiate integration of its blockchain into major platforms like Instagram and Opensea.
As markets corrected in 2022, Luna imploded spectacularly [JS1] and Solana has been the subject of a stead
y drip of negative headlines. Network congestion eventsa, during which the Solana blockchain is unusable, are somewhat frequent and can last for hours. We also recently learned that a single developer created nearly a dozen different DeFi protocols on Solana under different assumed identities, in a scheme to rehypothecate and artificially pump-up Solana’s total value locked (TVL) metric by billions of dollars.[1]
These are relatively minor incidents in comparison to the nightmare scenario that began August 2nd, in which thousands of Solana users suddenly had their balances drained en masse. Even addresses that had never interacted with a smart contract were drained, leaving many wondering if Solana private keys had somehow been compromised. So far, more than 9000 addresses have been affected and the attackers had absconded with more than $6mn USD worth of tokens.[2]
It is still not 100% clear what happened yet, but there are enough details available to write this blog post and confirm that it is safe to use Solana because this mass exploit happened at the app level, while the Solana blockchain operated as intended throughout.
The app at the center of the scandal is Slope, a Solana wallet app used to manage addresses that can send and receive crypto. Users would create a new seed phrase, a set of words used to generate and prove ownership of cryptocurrency addresses, or import an existing seed phrase into the Slope app to get started using it. When the Slope app later phoned home to company servers, it included this seed phrase in plain text format in the messages; this is one of the most embarrassing security flaws a crypto wallet provider could expose its users to. Independent testers were able to recreate the issue and see the seed phrases being delivered in plain text in the message payload. [3]
What has so far been confirmed is that at least some of breaches were due to these seed phrases being stored in plain text on servers. We presume that current investigation involves who had access to these servers and how the other 7779 addresses were drained.[4]
The initial recovery strategy of the Slope team was to ask the attacker(s) to return the funds and retain a 10% bounty:[5]
The deadline has passed and none of the money has been returned but the address has been sent multiple NFTs of questionable value.[6]
The Slope team has not yet provided a conclusion or breakdown of what has happened, presumably because they are still investigating. No other apps appear to be affected, unless the seed phrase imported to it was originally generated with the Slope app. If you have funds stored on addresses linked to a seed phrase created in the Slope app, immediately create a new seed phrase with a different app and send all funds to new addresses generated with it.
Solana is not suddenly less safe to use after this event. Seed phrase data from an app was exploited, which is not a Solana-specific issue. In any case, the safest option to store your cryptoassets is generally on a hardware wallet or with a regulated custody provider. Only keep small amounts that you are willing to lose on mobile wallets like Slope or Phantom.
[1] https://www.coindesk.com/layer2/2022/08/04/master-of-anons-how-a-crypto-developer-faked-a-defi-ecosystem/
[2] https://dune.com/tristan0x/solana-hack-3822
[3]https://twitter.com/0xfoobar/status/1554928011669118976
[4] https://twitter.com/slope_finance/status/1555100731706949639
[5] https://twitter.com/slope_finance/status/1555653747077877760
[6] https://solscan.io/account/DyQ96GwjkHkGSzYEB4NaPk2NxsXyRTMNHKJQd3fziABf
The main purpose of NYALA’s Next 11 index is to track 11 crypto assets that are on the cusp of mainstream adoption; not just would-be Ethereum killers but protocols that could propel the value created by blockchain technology to the next level. The index is partially inspired by Jim O’Neill’s attempt to identify the next 11 superstar emerging economies (after the BRICs) in 2005.
The constituents of the Next 11 index are reviewed on a quarterly basis and as usual, the rebalancing for Q3 2022 resulted in some turnover in the assets tracked by the index. We want to quickly present the assets added and removed to readers and followers of the NYALA blog.
Dapper Labs’ blockchain game, Cryptokitties, was the first so-called ‘killer app’ on Ethereum, generating so much activity and blockspace demand that it rendered the Ethereum network effectively unusable for extended periods of time. This experience drove Dapper Labs to create Flow, a blockchain with a focus on scalability and ease of developer and consumer onboarding. They claim that Flow can scale to serve billions of users without implementing complicated sharding techniques by splitting the role of a blockchain validator into four different roles: consensus, verification, execution, and data availability.
Flow first rose to awareness with the success of NBA Top Shots, an NFT project which allowed users to collect and trade highlight-reel video clips of NBA games and players. The hype around NBA Top Shots quickly died off and Flow has flown under the radar for the past year.
Luckily, Flow has a lot of money from fundraising to attract developers and very valuable intellectual property rights that can be leveraged to attract users. Furthermore, Flow is one of four blockchains that Meta’s Instagram will initially support as they integrate NFTs into their product (the other three are Ethereum, Polygon, and Solana). Finally, permissionless deployment of smart contracts has been enabled on Flow as of this week, opening the flood gates for many new dApps to be built on Flow soon [1].
FLOW is a gas token used to pay network transaction fees, a deposit token used to pay for storage on the network, and can be staked to secure the network.
The Cosmos ecosystem can be imagined as an “Internet of Blockchains”, a constellation of independent but interoperable blockchains that leverage the Cosmos SDK framework and use Tendermint as their consensus engine, with some exceptions. Blockchains in the Cosmos ecosystem increasingly communicate via the Inter-Blockchain Communication protocol (IBC), an interoperability protocol that ensures secure data and value transfer between the blockchains utilizing it.
Cosmos Hub can be thought of as a busy highway intersection, a central hub for IBC packet routing between blockchains within the Cosmos ecosystem. ATOM is the native token of Cosmos Hub, which can be staked to secure the network and vote in governance matters. As IBC moves towards a shared security model, similar to Polkadot’s relay chain approach, staking ATOM tokens would also contribute to the security of and collect fees from any IBC-connected blockchain in the Cosmos ecosystem.
THORChain is an independent blockchain built using the Cosmos SDK that functions as a cross-chain decentralized exchange (DEX) on which assets native to different blockchains can be traded against each other. For example, DOGE can be swapped for ETH using THORChain. A decentralized cross-chain DEX is a form of censorship resistance because it allows users to bypass centralized exchanges when they need to swap assets that are not native to the same blockchain.
THORChain’s cross-chain swaps are enabled by liquidity pools that pair each asset in the pools against RUNE, the native token of THORchain. With the support of arbitrageurs and cross-chain bridges, the correct exchange rate between all assets is maintained with the RUNE token as a sort of hidden intermediary. RUNE can also be staked to secure the THORChain network and vote in governance measures.
Please note that the removal of an asset from the N11 index should not be perceived as a negative judgement against it, unless otherwise stated. NAM follows a rules-based process to select new index constituents during each quarterly rebalancing, which leads to ongoing turnover of existing constituents.
A platform aimed at being a sort of swiss army knife for Ethereum scaling, integrating support for all possible scaling solutions instead of focusing on one or a few. This token has been promoted to the core index.
Kusama is a canary network, a production network with real value on it that is used to test the impact of software upgrades and other changes before rolling them out on the economically consequent Polkadot blockchain with which it shares it codebase.
Theta Network is a decentralized media streaming network which uses token incentives to crowdsource excess computational, storage, and network bandwidth resources that are used to provide high quality streaming video at low cost.
As interest rates rise and the tide of central bank stimulus that boosted markets during the covid years recedes, the cryptocurrency industry is undergoing an explosive deleveraging process. Vulnerable positions and faulty assumptions are being systematically tracked down and picked apart by markets. Due to the somewhat incestuous nature of the cryptocurrency industry, the largest pockets of unhealthy leverage are generally intertwined and interdependent, leading to a domino effect when one collapses.
The spectacular blowup of Terra and UST was only three weeks ago and already a leading major lending platform, Celsius, and market maker, Three Arrows Capital (3AC), look to be insolvent. Lido’s staked ETH product, stETH, and the billions of dollars of leverage riding on it also appear to be under increasing stress. This blog post will explain how these are all connected and provide some guesses as to where the contagion might spread next.
Celsius is a centralized lending platform with nearly two million customers [1] that offers high interest rates on deposited cryptocurrencies. Celsius has been able to offer this high yield to customers because it generated high income on their deposits by pledging them as collateral in DeFi protocols and providing them to market makers as unsecured loans.
To understand the company culture, clues can be found in the backgrounds of the management team. Their previous Chief Financial Officer was arrested in November 2021 on suspicion of money laundering, fraud, and sexual assault [2]. The current Chief Revenue Officer registered a business with a convicted money launderer in May 2021 [3]. The head of institutional lending starred in a widely distributed adult film. [4]
Impressively, Celsius managed to get the second largest pension fund in Canada, CDPQ, to invest in one of their funding rounds at peak valuation [5] and recently hired Rod Bolger, the former finance chief of the Royal Bank of Canada, as their new CFO. [6]
Celsius’ current solvency woes stem partially from the loss of hundreds of millions of dollars worth of customer funds since the beginning of 2021. It is reasonably well established that Celsius lost access to more than 38,000 staked ETH in early 2021 when Fireblocks, a crypto custodian, lost the keys that control them [7]. Celsius lost another 896 bitcoin in a December 2021 hack of BadgerDAO [8]. Celsius was nimbler in May 2022, pulling around half a billion dollars worth of customer funds out of Anchor Protocol unscathed before it collapsed [9].
An additional stress on Celsius is asset-liability duration mismatches of their own creation.
One of Celsius’ strategies was depositing large amounts of ETH into Lido’s liquid staking product and then borrowing stablecoins against the value of the receipt token, stETH. They currently have at least 409,000 stETH pledged as collateral in Aave.
To understand what stETH is, one must know that Ethereum is switching from a Proof of Work (PoW) to a Proof of Stake (PoS) consensus model. Once this transition is complete, ETH holders will be able to earn ETH-denominated yield by staking their ETH to secure the network. In preparation for this transition, there currently exists something called the “beacon chain” to which you can already stake your ETH to begin accruing this yield now. stETH is the token that represents ETH staked using Lido, both the value of the initial deposit and the subsequently accumulated staking rewards.
Common perception is that all stETH will be redeemable for ETH immediately following the transition to PoS, which is expected to happen this year. In reality, stETH redemptions will only be possible after a hard fork that occurs after this transition. The fork is not yet scheduled and will likely be up to a year after the transition. Even once redemptions become possible, the rate at which withdrawals are processed will be throttled over time. For these reasons, one can think of stETH as deferred coupon ETH bond with an unknown duration. The unknown duration of the stETH bond makes it essentially impossible to value against ETH with confidence and yet several billions of dollars in leveraged strategies and products were built on the premise that a roughly 1:1 stETH-ETH price peg will be maintained indefinitely.
So, when clients recently wanted to withdraw their assets en masse during market turmoil, Celsius was quickly unable to honor requests due to the above and paused all withdrawals on June 13th. The clients in the worst shape are those with open borrow positions on the platform that are approaching their liquidation price as the market sells off. Why deposit more collateral to save a position when it is unlikely that you will be able to withdraw any of your money in the end? As of the time of this publication, withdrawals are still paused and Celsius says they are engaging with lawyers about a restructuring of the company. [10]
The rapid fall of leading crypto market maker and prop fund, Three Arrows Capital (3AC), likely also contributed to Celsius’ recent problems. 3AC is generally thought to have lost hundreds of millions of dollars by investing in locked LUNA tokens and holding UST. Details are still very murky but it seems that 3AC has defaulted on loan obligations to many of its counterparties, even the exchange they own and are most associated with.
3AC is also selling large amounts of stETH for stablecoins, driving the exchange rate to ETH even further down and threatening Celsius’ leveraged stETH position.
Even before the extent of 3AC’s problems is fully known, those with funds remaining are nervously sizing each other up and trying to guess what the next domino to fall will be so that they can steer clear of it. Currently, the likeliest candidates look like:
Not everything is grim. Opportunity is born of every crisis. If you believe that the transition of Ethereum to PoS will happen, purchasing stETH at steep discounts from forced sellers is a very attractive proposition. [11] DeFi’s core infrastructure has also proven itself robust in the turbulence so far. Maker, Aave, Compound, and the like have processed billions of dollars in liquidations without major incident. Whatever and whoever remains after this wash out will come back many times stronger. Until then, we do what we must to survive.
[4] https://messari.io/person/jessica-khater-41298255
[5] https://www.ft.com/content/30854926-f9ca-4352-b17e-7e464b6a3a3d
[7] https://www.coindesk.com/business/2022/06/16/how-crypto-lender-celsius-overheated/
[8] https://blockworks.co/celsius-reportedly-affected-in-exploit-of-defi-protocol-badgerdao/
In the wake of the collapse of Terra, a debate is raging online over how best to engineer restitution for those left holding bags of $LUNA and $UST. Since our last article about Terra it has been revealed that the reserve fund to defend the $UST peg, previously worth billions of dollars, has been nearly entirely liquidated and will cover only a small fraction of total losses if repurposed as a recovery fund.
Rather than accept that the losses are largely irrevocable, the crowd focuses on engineering ways to recoup them via the means available: burning tokens and creating a new chain. Seasoned participants knows that these tactics are easy to sell when real solutions are unavailable but usually end in disappointment.
Coordinated burning of $LUNA and $UST is generally opposed by those with large balances, as they would need to sacrifice disproportionately for the plan to have any impact. They are more likely to vote „Yes“ for Proposal 1623, put forward by Do Kwon, Terra’s besmirched figurehead. The proposal involves spinning off Terra as a new blockchain without native support for algorithmic stablecoins. The old chain and its token will be deprecated to „Terra Classic“ and $LUNC; the new chain and token will take the flagship names „Terra“ and $LUNA.
The total supply of this new token will be airdropped in the following proportions (after excluding the balance of Terraform Labs‘ address):
A little bit more than 10% of the new token’s total supply will be transferable at mainnet launch and there will be a six month cliff before any further significant token unlocks occur. Proposal 1623 looks very likely to pass on May 25th at ~11:00 UTC, with nearly half of all eligible voting power already accrued to ‚Yes‘.
The elephant in the room with this plan is that minting UST and depositing it in Anchor Protocol for ~20% fixed APR created the overwhelming majority of the demand for $LUNA previously. If the new $LUNA is devoid of this utility, it is reasonable to expect that its initial recipients will race each other to sell their allocation first.
Another crucial factor in the success of the new chain will be how much support from centralized exchanges there will be in the form of distributing the new token to their clients and listing it for trading. This support does not look to be secured yet, seeing that the major exchanges which have $LUNA and/or $UST listed have been either silent or publicly disapproving of proposal 1623. Centralized exchanges can be expected to generally prefer plans that involve burning existing $LUNA, as it carries much less risk and expense for them than supporting a new blockchain for funding and trading.
In the end, the likeliest outcome is that there will be both a new chain with insufficient utility to gain real traction and a coordinated token burn on the old chain insufficient to adequately pump the price of the old token or revive the $UST peg and nobody will be fully satisfied. We hope that some miracle solution arises which allows everyone to recoup a significant amount of their losses, but prior experience leads us to emphasize the importance of prudent thinking in these scenarios.
NYALA recommended to clients and partners, specifically its subsidiary Wevest AG, to abstain from voting in proposal 1623 because the viability of the forked chain is uncertain. However, in the event of the fork going forward, NYALA will monitor the stability of the new chain before making any further recommendations to partners and clients. In any event, there will be a „Post-attack“ snapshot to be taken at Terra Classic block 7790000 (roughly 20:00 UTC on May 26th, 2022). The new Terra blockchain is planned to be launched a few hours after this snapshot.
If you are reading this, you have likely heard about and possibly felt the portfolio impact of Terra USD losing its peg to the US dollar in recent days. Students of the history of financial markets will observe that price pegs are like promises: they are often broken. This is doubly true of algorithmic stablecoins, a relatively new type of cryptocurrency that has blown up spectacularly with each iteration attempted. If you are wondering what exactly happened over the weekend and what might happen next, Nyala has you covered.
First, let’s familiarize ourselves with what a USD stablecoin is: a cryptocurrency that aims to maintain a 1:1 price peg with the US dollar. USD stablecoins come in three main flavors: fiat-backed, crypto-backed, and algorithmic.
Fiat-backed USD stablecoins such as $USDT and $USDC remain the most popular of the three, as measured by their collective market capitalization. These are, ideally, 1:1 backed by and redeemable for fiat currency held on deposit with traditional financial institutions.
Crypto-backed USD stablecoins are, as the name implies, backed by other cryptocurrencies. These are almost always heavily over-collateralized, to protect the price peg with the US dollar when the value of the underlying collateral falls. $DAI is far and away the most popular crypto-backed USD stablecoin.
Algorithmic stablecoins are backed neither by fiat nor cryptocurrency; rather, an algorithm expands and contracts the outstanding token supply to maintain the US dollar price peg. Put simply, the algorithmic stablecoin supply contracts when the price is below peg and expands when it is above peg. These types of systems typically also rely on market participants acting on arbitrage opportunities that help maintain the peg, without central coordination. It is important to note that after many failed experiments involving the concept (Empty Set, Iron Finance, etc.), algorithmic stablecoin protocols increasingly use some amount of collateralization to bolster confidence in their ability to hold peg during market distress events.
This brings us to Terra, a blockchain protocol focused on issuing algorithmic stablecoins. Terra’s native token is $LUNA and Terra USD ($UST) commands by far the largest market capitalization of any stablecoin it issues. Without going into the detailed mechanics, $LUNA is burned and minted by the Terra protocol as needed to maintain $UST’s 1:1 peg with the US dollar. Due to a confluence of factors, $UST’s market capitalization exploded from roughly $180mn USD at the beginning of 2021 to a peak of more than $18bn USD before the crisis it suffered in recent days. This is a 100x increase in a little more than a year! The price and market capitalization of $LUNA grew at a similar clip, contributing significantly to the performance of Nyala’s N11 index as a constituent. The purpose of Nyala’s Core Index is to provide exposure to the seven largest non-stablecoin tokens by market capitalization, a criterion that $LUNA fit during its recent inclusion in the Core Index.
Credit: Coingecko.comArguably, the two most important factors driving this rapid growth were Anchor Protocol’s deposit rate and the active involvement of market makers. As the variable yields that could be earned on stablecoins in the most popular DeFi protocols compressed during 2021 and year-to-date, Anchor Protocol’s ~20% fixed yield on UST became attractive enough to attract more than $11bn USD worth of $UST deposits at its peak, a few days ago.
Credit:Defillama.comAt the same time, to meet the increased demand for $UST driven by Anchor Protocol’s fixed yield, market makers worked with Terra to increase the amount of $UST that could be minted each day. To protect against certain types of speculative attacks, Terra sets a ceiling on how much new $UST can be minted or burned in a given period of time. By working to increase the liquidity of $LUNA across many centralized and decentralized exchanges, these market makers enabled Terra to loosen their liquidity parameters and mint new $UST at a much faster rate without (so they surmised) significantly increasing the risk of $UST losing its peg or a reflexive collapse in the price of $LUNA during market turbulence. Furthermore, the Luna Foundation Guard (LFG), a consortium of market makers and investors, has been raising billions of dollars in additional capital to be used as collateral that can be liquidated to defend the $UST peg during market turbulence.
This gambit turned out to be successful, and Anchor Protocol became a behemoth of retained capital. However, such a high fixed yield on such a large sum of deposits is not sustainable and the protocol had to be repeatedly topped up by LFG with additional funds to keep paying it out. Furthermore, in recent weeks, other blockchain protocols began to mimic this model and threatened to siphon this capital away from Anchor Protocol. Both the NEAR and Tron protocols announced that they would launch a native stablecoin that could be minted with NEAR and TRX tokens and deposited in Anchor Protocol clones offering fixed yields as high as 30%.
All of this exposition is required to understand the events of recent days. Over the weekend, an unknown party or parties began swapping hundreds of millions of $UST for other stablecoins held in Curve liquidity pools. The selling pressure was enough to throw the ratio of assets in the pool significantly out of balance, resulting in $UST trading further and further below the $1 peg. In response, members of LFG began liquidating hundreds of millions of $ETH and then $BTC in order to rebalance the liquidity pools and support the $UST peg on exchanges. Despite the monumental amount of capital burned to support the peg, the US dollar price of $UST sank to as low as $0.19 and still has not fully returned to $1.
Credit: Dune Analytics and @mhonkasaloCredit: Dune Analytics and @mhonkasaloCredit: Cryptowat.chRecent posts by Do Kwon, Terra’s public figurehead, indicate that UST will move to a collateralized model to restore confidence. It is also likely that Anchor Protocol’s deposit rate will need to be slashed significantly. Some action is already underway. At the time of publication of this article, a governance proposal to increase the rate at which UST can be burned in exchange for $LUNA is passing. This would significantly increase the inflation rate of $LUNA tokens and it appears that the market is frontrunning this measure passing by driving the price of $LUNA down even faster. The governance proposal in question can be found here:
https://station.terra.money/proposal/1164.
This appears to be an attempt to save the $UST peg at the expense of $LUNA price in the short term. However, because Terra relies on a Proof of Stake consensus mechanism, this would also decrease the cost and increase the probability of a chain re-organization attack that would render the network effectively unusable. Terra is currently between a rock and a hard place.
However, this is crypto and the outcomes are often surprising or absurd. Perhaps this final capitulation on the concept of fiat-pegged algorithmic stablecoins will reignite interest in mechanisms such as OlympusDAO, which has amassed an enormous treasury to experiment with different methods of bootstrapping an internet-native reserve currency that does not attempt to peg itself to a fiat currency. We will be watching the situation develop with great interest while continuing to avoid direct exposure to $UST and other algorithmic stablecoins for the foreseeable future.
The main purpose of NYALA’s Next 11 index is to track 11 crypto assets that are on the cusp of mainstream adoption - not just would-be Ethereum killers but protocols that could propel the value created by blockchain technology to the next level - there is a rough analogy here to Jim O’Neill’s attempt to identify the next 11 superstar emerging economies (after the BRICs) in 2005.
Since its inception in August 2021, the N11 index has had a spectacular performance (145%) and has easily outperformed Bitcoin and Ethereum. In order to maintain this positive track record, the index composition is revisited on a quarterly basis. At the end of Q1 2022, a number of new constituents were added and some were retired. We want to quickly present these assets to readers and followers of the NYALA blog.
Chainlink is the current gold standard of blockchain oracle networks, the primary purpose of which is to feed smart contracts with off-chain, real-world data that cannot be tampered with. For example, a smart contract that facilitates the trading of synthetic equities might rely on Chainlink to provide the current price of the FTSE 100 index. As the number of smart contracts and blockchains hosting them rapidly proliferates, so grows the need for a secure and standardized cross-chain messaging protocol that allows assets and data moving across blockchains with heterogeneous security guarantees to be treated as fungible. Chainlink’s Cross-chain Interoperability Protocol (CCIP) will leverage the existing network of Chainlink nodes to meet this need, while also improving their off-chain computational abilities to enable cross-chain smart contract execution. Cross-chain smart contracts would host different parts of their codebase on multiple blockchains, analogous to hosting different parts of a software stack on multiple cloud environments for efficiency. LINK is currently a payment token, used to pay node operators for providing oracle services. LINK staking is currently slated for 2022 release; node operators will need to stake LINK tokens as collateral before being able to provide oracle services.
NEAR is a Proof-of-Stake (PoS) smart contract platform that aims to be as developer-friendly as possible and support high transaction throughput, at any scale. The latter is achieved with „dynamic re-sharding“, a scaling solution which adds and removes throughput-boosting blockchain „shards“ as needed. In addition to Ethereum Virtual Machine (EVM) compatibility, NEAR supports next-generation WebAssembly (Wasm) environments for smart contract execution. NEAR tokens are used to pay network transaction fees and vote in protocol governance measure. They can also be staked or delegated to nodes validating transactions. An uncommon feature of NEAR is that 30% of transaction fees spent interacting with any smart contract are rewarded to the creator(s) of that smart contract, with the intent of further incentivizing the development of applications on NEAR that increase network use.
We welcome NEAR as one of the new protocols in our indexFantom - FTM
Fantom is an EVM-compatible PoS smart contract platform with a novel consensus model, named „Lachesis“, which enables very fast transaction finality. Fantom aims to be a hub for Decentralized Finance (DeFi) and enterprise blockchain services. Despite the recent departure of two key technical advisors from the Fantom Foundation, Andre Cronje and Anton Nell, Fantom still has an active development community and a growing number of DeFi applications that manage several billion US dollars‘ worth of assets. FTM tokens are used to pay network transaction fees and vote in protocol governance measures. They can also be staked or delegated to nodes validating transactions.
Maker is the progenitor of one of the earliest DeFi primitives, the cryptoasset-collateralized stablecoin. Maker has two native tokens: MKR and DAI. DAI is a stablecoin that aims to maintain a 1:1 price peg with the US dollar. New DAI tokens can be minted by locking up cryptoassets, such as ETH, in a smart contract as collateral and borrowing DAI against them. MKR tokens are used to maintain economic equilibrium in the Maker ecosystem by being burned or minted to absorb any excess or shortfall in DAI supply. MKR can also be used to pay the „Stability Fee“, a variable interest rate charged to DAI borrowers that supports DAI’s peg to the US dollar. With increasing regulatory scrutiny trained on stablecoins and nation states more frequently targeting the assets of individuals for financial sanctions and seizures, DAI and other stablecoins that purport to be decentralized enough to resist seizure will continue to grow in popularity.
Theta Network is a decentralized media streaming network which uses token incentives to crowdsource excess computational, storage, and network bandwidth resources that are used to provide high quality streaming video at low cost. Theta Network has a dual network design: the Theta blockchain provides payment, reward, and smart contract capabilities, while the Theta Edge network is responsible for the storage and delivery of media. The THETA token can be used to vote in governance decisions and staked to nodes that earn TFUEL tokens. Theta Fuel (TFUEL) is the „gas token“ of Theta Network, used to pay for media content streams and smart contract interactions.
Kusama is a canary network, a production network with real value on it that is used to test the impact of software upgrades and other changes before rolling them out on the economically consequent Polkadot blockchain with which it shares it codebase.
A platform aimed at being a sort of Swiss army knife for Ethereum scaling, integrating support for all possible scaling solutions instead of focusing on one or a few.
The Swiss army knife for Ethereum defends its position in the Next11 index
Filecoin is the incentivization layer of the InterPlanetary File System (IPFS), creating a marketplace for data services which aims to be competitive with centralized incumbents such as Amazon Web Services.
A smart contract platform with the unique Pure PoS (PPoS) consensus mechanism, which does not reward nodes for validating transactions and aims for immediate transaction finality.
A decentralized wireless network which self-propagates by rewarding Helium Hotspot operators with HNT tokens in proportion to their contribution to network size and signal strength.
A decentralized money market which offers non-custodial borrowing and lending at both variable and fixed interest rates on many blockchains.
Please note that the removal of an asset from the N11 index should not be perceived as a negative judgement against it, unless otherwise stated. NAM follows a rules-based process to select new index constituents during each quarterly rebalancing, which leads to ongoing turnover of existing constituents.
A decentralized exchange with the deepest liquidity for stablecoin-to-stablecoin trades and such a core piece of DeFi infrastructure that many vie for control over its governance in what has been dubbed „The Curve Wars“.
An algorithmically governed stablecoin platform which mints and burns its native LUNA token as needed to maintain the price peg of the stablecoins it issues, the most popular of which being the US-dollar-pegged UST. LUNA is now a constituent of the Core index.
LUNA got promoted and is now part of our Core indexCosmos Hub - ATOM
The Cosmos network is an ecosystem of independent blockchains that increasingly communicate via IBC, an interoperability protocol that allows secure data and value transfer; Cosmos Hub is the locus of IBC packet routing among blockchains within the Cosmos network.
A blockchain in the Cosmos network that serves as a cross-chain decentralized exchange, allowing for non-custodial trades of the native assets of different blockchains.
One of the earliest „metaverse“ blockchain projects, Decentraland is a virtual world which settles in-world commerce and real estate transactions on the Ethereum blockchain.
NYALA offers institutional investors and financial service providers product solutions and API services for digital assets in the core business areas of tokenization (issuance of digital securities) and asset servicing (trading, reporting, access to trading venues). With its own licenses for investment brokerage and financial portfolio management, NYALA is the leading crypto-as-a-service partner and one-stop store for tokenized securities issuance. NYALA Asset Management provides banks, investors and companies with a professional asset management unit that creates easy access to the digital asset class. Renowned banking partners such as Hauck & Aufhäuser and issuers such as Invesdor AG already rely on NYALA’s services. NYALA offers wealthy private clients access to regulated asset management with crypto assets in Germany through its subsidiary wevest Vermögensverwaltung AG.
