Review of the YFI plunge and dYdX liquidation and liquidation events: these six points are worth paying attention to

Last weekend, one of the biggest stories that happened in the on-chain world, which can also be called an accident: the “attack” of dYdX.

YFI posted a drop of about 45% in a single day. The crash affected long positions on dYdX, resulting in a cascade of liquidations of positions on dYdX, with nearly $38 million liquidated.

Due to the rapid decline of this time, there was a funding gap at one point, and dYdX paid a price of $9 million.

In the aftermath of this incident, reactions from all parties, including dYdX and the community, have been mixed.

Odaily has sorted out 6 key questions around this event.

How do market movements occur?

dYdX market data shows that YFI has continued to rise since the beginning of this month. Prior to this incident, the price of YFI had already risen by more than 200% in this rally.

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On November 18th, Yearn.finance (YFI) took an unexpected move. The YFI price fell 45% in a matter of hours, falling from $14, 500 to $8, 300, engulfing recent gains. More than $250 million in market capitalization evaporated, dropping from $525 million to $275 million.

In the midst of this drastic decline, dYdX’s user positions have also suffered a huge series of liquidations.

On-chain data shows that nearly half of the entire supply of YFI is held in 10 wallets. Therefore, some people believe that this plunge is manipulated by insiders.

Lookonchain monitoring shows that an anonymous user deposited a large amount of USDC into dydx from multiple addresses, which is suspected of being a long operation on YFI. And when the YFI price peaked on November 17, it was speculated that the user might have opened a long short. This speculation is supported by the fact that the user withdrew a large amount of profit from DYDX after the price crash on the 18th.

Previously, on November 1st, the price of SUSHI fluctuated wildly, and this anonymous user used the same method to try to profit by manipulating the price of SUSHI.

According to data platform Arkham, YFI typically has very low trading volume on dYdX. This also shows that the liquidity of the token is not sufficient, and the price is very easy to be manipulated in the face of a large amount of funds.

How did the $9 million liquidation gap come about?

As we all know, when a user performs a “buy/sell” operation, there must be an opposite counterparty who is performing a “sell/buy” operation. “Liquidation”, as a trading operation enforced by the system, naturally follows the logic of ordinary transactions.

When the market is in a fast-moving extreme, the liquidated “sell/buy” may face a sudden drain of liquidity, and the transaction lacks sufficient counterparties. Imagine that if an underlying falls to $100, the user’s position needs to be sold at the current price to be successfully reversed, but the price continues to fall to $90 before the sell action is completed, and the user’s net asset value becomes negative.

The Mango attack, previously reported by Odaily, is similar.

“Attack” or “Transaction”?

After the dYdX liquidation time occurred, dYdX founder Antonio Juliano posted on social platforms that the YFI open interest on dYdX soared from $800,000 to $67 million in a few days, and that dYdX had raised the initial margin ratio of YFI before the YFI price plummeted, but this failed to prevent the event from happening.

Antonio noted that this was clearly a “targeted attack” on dYdX, including market manipulation of YFI as a whole. He also said that in response to these incidents, dYdX will work with multiple entities to conduct a full investigation to uncover the details of the alleged attacks. The aim is to maintain transparency with the community regarding the results of the survey.

Intriguingly, is it reasonable to define this behavior as an “attack”? As was the case with the previous discussion following the Mango hack, there was a view in the community that trading from the open market did not necessarily seem to be defined as an attack.

For the “attacker”, this behavior can undoubtedly be called “market manipulation”. However, in the absence of technical “hacking” behaviors such as system intrusion, vulnerability exploitation, and private key theft, it is debatable whether this alternative “manipulation” method can be called an “attack”.

How does the dYdX Insurance Fund work?

In the aftermath of this incident, one of the key points of discussion in the community was the rationality of the use of the insurance fund.

According to the official dYdX documentation, if a user’s account becomes “insolvent”, such account must be disposed of immediately in order to ensure the solvency of the entire system. And how can a user balance already be negative, how can it pay for the loss? Therefore, the insurance fund becomes the backstop for liquidation in extreme cases.

The existence of the insurance fund maintains the solvency of the system. When the account will be liquidated, the insurance fund will bear the loss. In the official documentation, dYdX also gives a clear explanation of this: the insurance fund is not decentralized, and the dYdX team will be directly responsible for the deposit and withdrawal of funds.

The team also stated that some aspects of the decentralized fund may be decentralised in the future, but in the initial phase, the priority is to ensure that insolvent accounts are dealt with in a timely manner.

What happens if the insurance fund is depleted?

At present, dYdX’s official data shows that after the payment of about $9 million in the insurance fund, there is still $13.86 million left in the insurance fund, which is only enough to withstand about one more “YFI incident” of the same level.

If the insurance fund is depleted, the negative balance account can be offset with the positions with the highest profit and leverage to maintain the stability of the system. Deleveraging is a socialized loss mechanism that requires profitable traders to contribute a portion of their profits to offset insolvent accounts.

After deleveraging has occurred, the account with the highest leverage will be deleveraged first. Specifically, the platform will automatically force a reduction in the positions of a part of the traders, giving preference to accounts with a combination of high profit and high leverage, and using their profits to offset insolvent accounts.

Given the significant impact that deleveraging has on users, deleveraging is only used when the insurance fund is depleted.

Who is the next dYdX?

The public statement of dYdY in this incident stated that “dYdX has now banned high-profit trading strategies”.

What is a “High Profit Trading Strategy”?

The term comes from the famous 2022 Mango Markets $116 million attack. Avraham Eisenberg, the initiator of this attack, called the “manipulation of spot market price + high leverage profit in the contract market” model used by himself as a trading strategy. He argued that all of the open market activities he had carried out were legitimate and did not constitute an “attack”.

Although this incident caused an uproar last year, did this incident really bring a lesson to the industry?

When discussing the issue of decentralized derivatives trading platforms, we have to face a reality that cannot be ignored: the lack of liquidity. As recently demonstrated on the dYdX platform, the combination of price manipulation and illiquidity becomes a dangerous and recurring pattern. This not only reflects the challenges inherent in decentralized platforms, but also exposes the vulnerabilities of the cryptocurrency market.

In the wake of the event, the dYdX founders have introduced a series of updates to dYdX, including: market updates will be easier to make it easier for the market to generate higher liquidity, maintenance margin functionality will become updatable (previously not supported in V3), maintenance margin functionality will be able to change with position size (previously not supported in V3), redesign of the liquidation engine, and withdrawal requirements with any negative equity will not be accepted (until the underlying position is liquidated).

Although a series of measures have brought new changes to dYdX, is this the end of such an event?

The Mango incident illustrates that it doesn’t seem difficult to manipulate the spot price of a coin when illiquid tokens appear. The consequences of the dYdX incident are just a “repetition” of the previous one.

Last time it was Mango and this time it was dYdX, but this pattern is likely to be repeated on other platforms, leaving a profound lesson for the industry each time. The lack of liquidity has brought too many bad consequences to the crypto industry. This recurring question reminds us that the crypto ecosystem is far from mature, and that investors and developers alike must adopt a more cautious strategy. It is only through the collective efforts of the industry and continued innovation that we can truly realize the potential of DeFi while minimizing its risks.