Happy Tuesday!

Another day, another decentralized bank run. For today’s newsletter, we break down the crisis at THORChain, and what it means for the wider world of DeFi and BTC synthetics.

THORChain is insolvent, and stakeholders are scrambling for a fix

Last week, it became clear that THORChain, a cross-chain lending protocol, is insolvent. This sent the network’s native token RUNE on a 30% downward spiral to $2, causing node operators to pause withdrawals until THORChain stakeholders can agree on a way forward.

What happens next? We’ll soon figure out what happens to the $40 million in bitcoin locked in the protocol.

What is THORChain?

THORChain is a cross-chain lending protocol for bitcoin, ethereum, stablecoins, and other cryptocurrencies. Proponents of THORChain like Erik Voorhees tout that THORChain allows users to “permissionlessly trade” assets via the protocol. 

To use THORChain, users deposit crypto assets, like bitcoin, ether, and stablecoins, into THORChain’s liquidity pools. Each asset is paired with RUNE, the native token of the protocol, which is used to facilitate the cross chain swaps and incentivize node operators. The network issues new RUNE as deposits and liquidity requirements increase. The sprawling THORChain system itself is quite complex, however, which has played a role in obfuscating the protocol’s path toward its current insolvency.

As of last Thursday, the protocol had $97 million in lending liabilities and $102 million in native or pegged assets (for a total of $199 million), almost double the ~$107 million assets locked in the network. The total market cap of the chain’s token was over $1 billion at the time, value that would be vaporized when the network can no longer honor locked asset redemptions.

To oversimplify: new RUNE has to be issued to match deposits and when the net value of issued RUNE falls below the value of locked assets, the network becomes insolvent. The rest of the normally issued RUNE is staked and receives protocol revenue, but if the protocol cannot generate revenue anymore because of an insolvency or bank run, then the value thesis of the entire chain collapses and thus the price of the staked RUNE.

On Thursday, THORChain nodes agreed to halt deposits and withdrawals while stakeholders sort out the crypto protocol equivalent of bankruptcy.

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How did THORChain go insolvent?

Some onlookers, like Lava CEO Shezhan Maredia, foresaw such an insolvency years ago. 

“When you borrowed on THORChain, they would sell your BTC collateral for their own token, RUNE. If you repaid your loan, they would need to sell RUNE for BTC to give you back your collateral,” claims Shezhan. “But, this leads to a death spiral opportunity as decrease in RUNE price leads to more people wanting to get their BTC back from THORChain which leads to more RUNE being sold which leads to a decrease in RUNE price and so on.”

In other words, THORChain as a protocol is short bitcoin and ether by design. This creates intractable problems for debts that network participants cannot pay if bitcoin continues to appreciate in value. Many have pointed out that this design is structurally similar to Terra/Luna, an algorithmic stablecoin network that blew up in the summer of 2022.

Regardless, the THORChain network does generate significant revenue – about $30m in fees per year. This cashflow could be redirected to pay down debt, as one THORCHain user has proposed.

Why does this matter for Bitcoin?

There’s currently over $40 million of bitcoin and bitcoin synthetics like WBTC on THORChain. The unwind of THORChain would be a blow to wrapped bitcoin assets on other chains and the entire bitcoin-denominated DeFi landscape. We may have already seen some of the effects of this as savvy users began pulling their BTC from THORChain in December when there was ~$80 million BTC locked in the network. 

The other takeaway is that, as wrapped bitcoin continues to proliferate across the multibillion DeFi ecosystem, chain collapses and insolvencies are increasingly intertwined with bitcoin’s overall market. 

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