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xUSD is undergoing a major depeg and default event following a $93m hole in their balance sheet resulting in $280m of leverage unwinding. Let’s break down what is happening:
What is xUSD and Stream Finance
Stream Finance operates numerous vaults, which effectively are managed as onchain hedge funds. xUSD in particular is described as “ takes advantage of market neutral strategies to earn high yield. This strategies vary from lending arbitrages, to incentive farming, to dynamically hedged HFT, to market making.”
xUSD has 382m$ of AUM which is offering an estimated 18% yield. Today, Stream announced that an external fund manager which was running their book lost 93m$.
x.com/StreamDefi/sta…
The reason this is causing such a tremendous amount of collateral damage is not only because of the 93m$ hole in their balance sheet, but what the rest of the balance sheet is comprised of.
The xUSD Loop
A core part of the yield generation strategy was aggressive looping using xUSD as collateral. A part of this strategy surrounded a bespoke looping agreement with Elixir, but additionally xUSD was deposited across various lending markets to borrow collateral (such as USDT0) and this collateral was used to mint more xUSD. Repeated multiple times such that an initial 1$ deposit may mint several $ of xUSD. As a result, Stream became the major holder of xUSD. It is today not fully clear exactly what is backing xUSD as there is a missing transparency report, but various onchain resources that I have assembled pieced together the story.
The primary reason for the looping strategy is to harvest various forms of yield arbitrage in lending markets, with the added benefit of significantly inflating AUM for xUSD as well as partnering protocols. It’s unclear if the strategy was somehow nefarious or simply excessive risk taking gone wrong.
As the market internalizes the $93m hole in the balance sheet, a major unwinding of all these loops are currently occurring. Let’s dig into the adjacent impact across the DeFi ecosystem.
Elixir Impact
deUSD from Elixir was borrowed in a bespoke agreement to Stream with xUSD as collateral. Elixir is the only debt holder with a 1:1 claim to xUSD redemptions.
x.com/elixir/status/…
The exposure is 68m USDC, about 65% of deUSD backing. Supposedly, the bespoke agreement shields Elixir as a senior debt holder in this story which is alleviating some of the concerns about deUSD’s backing. However, questions remain about the ability to repay the loans from Elixir, which has resulted in significant peg volatility for sdeUSD.
Lending Market Impact
xUSD was widely used as collateral, mostly on L2s such as Plasma, where it was aggressively levered using hardcoded oracles. A full rundown of the affected lending markets was compiled by YAM with combined exposure of $284.96m.
x.com/yieldsandmore/…
To use the largest market as an example, let’s examine xUSD on Euler on Plasma. $107m of xUSD is supplied with a hard-coded oracle at 1.27$. The collateral is used to borrow USDT0, plUSD and msUSD. Each of these lending markets are facing a serious amount of bad debt. Actual liquidation and clearing of this bad debt will likely pend the full bankruptcy of xUSD due to the hardcoded oracles.
Oracle design and lender losses
The above example may be the largest single loss for DeFi lenders (non-exploit related) and underpins the real risks of lending to high risk assets with hardcoded oracles. Lenders in these markets will be stuck for the foreseeable future as liquidations are blocked by the oracle. The borrower (xUSD) will face a 75% borrow APY in the meantime which further increases the losses for Stream. So far, Morpho Vaults on Ethereum mainnet seem largely unscathed. However, fear both tied to deUSD as well as broader contagion risk is pushing several of the largest vaults to 40%+ yields as many markets have limited excess liquidity as loops are being liquidated and lenders withdraw their funds.
A significant part of the xUSD has been converted to other yield bearing tokens to perform loop arbitrage. A major exposure is Midas mHYPER (which is fully backed!), that was minted and looped on Morpho. Currently at a 90m$ market size and 65% borrow rate, this loop is being unwound by xUSD.
This major spike in borrow rates across numerous assets is resulting in loop unwinding for other market participants. The issue is exacerbated by a general liquidity shortage following the Balancer exploit, Black Friday and overall negative price movements.
Solutions and lessons
We built @corkprotocol for these exact types of events, it can both act as a redemption buffer for liquidity crunches as well as a risk market to price risk and enable users to hedge against losses.
Ultimately, the culprit is excessive risk taking, rehypothecation and poor transparency for xUSD depositors.
Oracle design played a major role in amplifying the issue, if Euler markets were not hardcoded, less bad debt would have accumulated and positions could have been liquidated when there was existing AMM liquidity. Hopefully we as a space consider adopting alternative approaches to oracle design.
The story is still evolving, please give @robdogeth, @talkintokens and @corkprotocol a follow if you want to stay up to date on this event as it unfolds.
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