An exploration of one of 2021’s most hyped DeFi protocols and its ambitions to become a decentralized reserve currency
It’s been called a Ponzi scheme by doubters, a liquidity black hole by analysts and a potential future reserve asset by the team behind it. OlympusDAO, with its heavy meme culture, strong community and innovative tokenomics, has taken the cryptocurrency industry by storm this year. Just browse Crypto Twitter and it’s only a matter of time before you’ll see the OlympusDAO badge of honor — the mysterious nod to the protocol’s game theory, (3, 3), (1, 1) or (9, 9) — among the many pseudonymous handles.
Launched just over half a year ago, OlympusDAO has quickly surged to a more than $3 billion market capitalization at its recent all-time high. Data provided by a dedicated Dune Analytics dashboard shows the project also boasts impressive community staking statistics, with often more than 90% of the circulating supply earning yield for its holders, and a treasury of almost half a billion dollars. Perhaps most impressive of all — and potentially revolutionary for decentralized finance — OlympusDAO owns almost 100% of its DEX liquidity, thanks to its innovative bonding system.
But what is OlympusDAO, how does it work and can it really achieve its lofty goal of creating a reserve asset entirely unconnected to the regnant financial system? In this in-depth article, OKX Insights attempts to answer these questions, assesses the protocol’s risks and more. Before that, though, we begin by explaining exactly why Olympus’s OHM token was created in the first place.
Crypto’s centralized crutch
An asset that is able to preserve purchasing power in a hugely volatile market like that of cryptocurrency is highly desirable. Since the first successful stablecoin, USDT, launched in 2014, the combined market capitalization of the asset class’s most prominent examples has swelled to a massive $127 billion.
For trading in and out of hugely volatile assets like BTC and other digital currencies, the lower regulatory and logistical overheads accompanying these fixed-price assets make them a popular alternative to fiat currency for exchanges like OKX and others. As such, the controversial stablecoin USDT routinely tops the charts in terms of volume — even despite its regulatory struggles and questions over its actual backing throughout the years.
Yet, up until recently, efforts to create some form of stability have brought the cryptocurrency industry closer to the very system it is trying to replace. Dominant stablecoins today are issued by a central authority, such as Tether. Naturally, this is an ill fit with the decentralized aspirations of those drawn to cryptocurrency. However, such concerns largely go unspoken or are considered a necessary evil, as viable alternatives are lacking and few rebuke the importance of maintaining stable purchasing power when conducting various financial activities.
There is a strange irony that many cryptocurrency traders flee to USDT, USDC or similar centrally issued stablecoins when they perceive there to be an incoming industry-wide price drop. After all, the dollars backing these crypto assets aren’t really stable at all.
Despite the industry’s disdainful rhetoric toward the United States dollar and the Federal Reserve’s ability to depreciate its value at will, much of the market’s activity remains dependent on it. Blockchain technology has yet to produce a viable decentralized alternative that is not inextricably linked to an existing monetary policy. Can we really call something a stablecoin when the purchasing power of the currency backing it decreases over time at the behest of central actors?
In correspondence with OKX Insights, an OlympusDAO Partnerships and Policy contributor, who goes by the handle xh3, elaborated:
“What you want when you hold a stablecoin is to maintain your purchasing power over time, which is actually not possible if you hold something that is equally valuable to fiat money like USD because there is not only supply inflation in the U.S. monetary system but also price inflation. In other words, you just lose over time when you hold fiat.”
Alongside the depreciation of the dollars backing many centrally issued stablecoins, there are other problems with the major stablecoins today. Anyone who has spent any time around the cryptocurrency industry will be aware of Tether’s legal woes regarding USDT’s backing. While independent financial audits can help provide assurances that each unit of a stablecoin is fully asset-backed, relying on such services to verify a company’s claims does not sit well with the “don’t trust, verify” ethos that pervades much of the industry.
Additionally, centralized stablecoin issuers are increasingly becoming targets for regulators and legislators, as illustrated by the proposed Stablecoin Tethering and Bank Licensing Enforcement Act, a bill introduced in the U.S. House of Representatives in 2020. The legislation, if passed, would require issuers to obtain a federal banking charter and would also enforce KYC and AML reporting requirements, which some believe would be an attack on financial privacy. The assets custodied by centralized stablecoin issuers like Tether are also vulnerable to seizure, should regulatory bodies become more hostile toward them. All told, these centrally issued and bank reserve-backed efforts are a far cry from the decentralized monetary system outlined in the Bitcoin white paper that spawned the entire crypto industry.
Decentralizing stability?
While the dominant stablecoins in use at centralized exchanges and throughout the DeFi ecosystem remain those backed by centrally custodied assets, the cryptocurrency industry has experimented with more decentralized approaches.
The first of note is MakerDAO’s DAI. In its earliest days, DAI was backed exclusively by ETH. To compensate for ETH volatility, the protocol demands that users put up more ETH in collateral than the dollar value of the DAI they want to mint. This over-collateralization is intended to keep the protocol solvent in the event of a major market downturn.
The problem with this approach is that it is not a very efficient use of capital. To get around this and protect against ETH volatility, DAI is increasingly becoming backed by centrally issued stablecoins, such as USDC. According to data-provider Dai Stats, around 43% of DAI generated today is backed by USDC, and a further 8.4% is backed by Wrapped BTC, which suffers from its own issues with centralized custodians.
Additionally, DAI is intended to retain the purchasing power of $1 — which, as mentioned, depreciates in accordance with Federal Reserve policy. Despite claims to be a decentralized stablecoin, DAI remains linked to the existing system that many in crypto are attempting to leave behind.
Other efforts to create decentralized stability have (arguably) greater issues. Take, for example, the class of algorithmically issued stablecoins that became popular at the end of last year. Projects like Empty Set Dollar, Based Protocol and others introduced protocol-controlled supply adjustments in response to varying demand. Notably, these efforts are entirely unbacked and rely on algorithms alone to find their target price.
While such projects appear to offer a more decentralized alternative to DAI, USDT or USDC, they are flawed for other reasons. Firstly, almost all algorithmic stablecoins again attempt to mirror the USD price. Secondly, they just aren’t that good at maintaining their peg.
As OKX Insights explored in an earlier in-depth article, it is much easier for an algorithmic stablecoin to maintain its peg when its market capitalization is expanding. Minting new units to dilute supply and reduce price is reasonably effective when the market is confident. However, when enthusiasm wanes, the buyers required to push the price back up often aren’t forthcoming. This can lead to a so-called “death spiral” in which those holding the token continue to sell at prices below the peg as they fear the price will never reach the target again. This is the exact opposite of what is needed to restore the peg.
OlympusDAO’s decentral bank
As outlined, most current efforts to create a stable currency are flawed precisely because of their ties to the existing fiat monetary system. Taking a different approach, however, is a relatively new protocol that does not rely on centralized custodians or inefficient over-collateralization. Indeed, OlympusDAO, with its Ethereum-based OHM token, does not even attempt to mirror the dollar’s purchasing power.
In the words of pseudonymous Olympus founder Zeus, cited in a July 2021 Medium article:
“There’s a strange irony to the fact that the most utilized cryptocurrency is really just a digitized dollar. While functional stablecoins may achieve a stable USD value, that does not mean they’re stable in purchasing power. Their real value changes just like dollars in a bank account.”
Instead of attempting to peg to the dollar, OlympusDAO borrows from the techniques used by the central banks of old to create an entirely new asset that it hopes can eventually serve as a stable reserve currency for the DeFi sector and beyond. The OHM token is not pegged to the value of the depreciating U.S. dollar. Instead, it is backed by a basket of decentralized assets, and its price is allowed to float above the value of those assets backing it.
The protocol must hold at least 1 DAI to mint every new OHM entering circulation, and it expands its supply as it accrues more capital to back new issuance. These increases of the supply are distributed to those supporting the project by staking OHM. Every eight hours — a period known as an “epoch” — the protocol awards a percentage of the amount staked, which is automatically added to the staker’s position. This has the effect of compounding rewards and is, in part, responsible for the massive annual percentage yields (currently around 8,000%) that have attracted a large community of participants and plenty of naysayers crying “Ponzi.”
Confronting DeFi’s “mercenary capital” problem
Such bumper yields are nothing new in the cryptocurrency industry. When a new application launches, those behind it will often attempt to bootstrap the protocol by paying those providing liquidity with freshly minted tokens. Throughout mid-2020 — a period known as DeFi summer — countless protocols leveraged this model to attract participants.
The issue with such an approach is that these apparent “supporters” don’t necessarily support the protocol. They are simply drawn in by the massive yields, and, once these dry up, they move on to the next most profitable opportunity. This places those behind the protocols in a tough spot. Reducing yields discourages liquidity providers. Yet, maintaining them dilutes the token supply.
In many cases, a protocol’s treasury is largely composed of its own native tokens, meaning that the protocol itself is constantly paying for liquidity that could disappear at any moment. As soon as it stops offering such attractive rates, liquidity providers disappear and the project risks drifting into obscurity.
OlympusDAO attempts to get around this with a concept it calls protocol-owned liquidity. Rather than effectively renting liquidity from token holders, OlympusDAO buys it outright using its OHM tokens. Using its innovative bonding system, the protocol offers OHM at a discount to its current market price in exchange for the liquidity pool tokens issued to those providing liquidity to decentralized exchanges like SushiSwap. When users buy one of these LP bonds, they are in fact selling Olympus their share of that liquidity pool, as well as any future rewards the LP tokens stand to generate. Olympus’s treasury benefits both from increasing its share of the given liquidity pool (i.e., owning more assets) and from receiving the rewards generated via fees users pay for using said pool. Similarly, the bond-holder is both able to acquire OHM (vested over a five-day period) at a discounted rate and to subsequently earn yield for staking it.
The system has been remarkably successful for Olympus thus far. At the time of writing, the OlympusDAO dashboard reports the DAO itself controls a massive 99.92% of all OHM-DAI liquidity. By owning liquidity instead of renting it, Olympus is much less likely to suffer from a sudden drain of capital that would harm the project’s long-term ambitions.
This bonding system also finances the project’s consistently high yields. When users take a bond, they contribute either LP tokens or another asset that the DAO’s treasury holds. As the treasury expands, it can afford to back the OHM tokens it mints and then distributes to stakers with greater capital. Over time, each OHM token’s backing has increased. Today, the market value of the assets backing every circulating OHM is around $105.
Despite its growing treasury backing the OHM in circulation, the protocol itself always values OHM at 1 DAI. It effectively pays 1 DAI to mint every new OHM, but it sells the newly created OHM at a discount to current market price via the bonding system — with the treasury profiting from the difference. For example, let’s suppose the OHM price is $800, and that buying a bond with DAI results in a 10% discount. The protocol sells the OHM to the bond-holder for $720, which it created for 1 DAI, and makes a significant profit.
The bonding system is just one part of OlympusDAO’s profit-generation activities. By controlling its own liquidity, it also benefits from the trading fees paid by those buying and selling OHM on DEXs like SushiSwap. Additionally, the project’s latest product, Olympus Pro, offers the bonding infrastructure to other DeFi applications for a percentage of the future profits generated through bond sales.
These diverse revenue streams result in significant profits for the DAO’s treasury, enabling it to maintain the colossal yields that have attracted so many to the project. The premium itself is a direct result of these yields. Essentially, people are willing to pay much more than the value of the assets backing each OHM for the opportunity to generate the four-figure yields promised into the future, thanks to OlympusDAO’s growing treasury.
A not-so-stablecoin?
While the overarching goal of OlympusDAO is to create a relatively stable asset that has as few ties to the regnant financial system as possible, for now, the focus is not on stability. Instead, the protocol favors rapid expansion. During this initial phase, the primary objective is to build as large a treasury as possible.
Over time, as the treasury’s growth slows, the yield is expected to decrease — and, presumably, the premium participants are willing to pay for OHM will fall alongside it. This should have the effect of reducing OHM’s price volatility over the long term. Yet, it remains to be seen whether the OHM community will stick around when the yields dry up.
While the project’s goals are certainly noble — reducing DeFi’s dependence on USD is something that many would love to see — the fact remains that many investors act in their own short-term interest rather than the long-term viability of the decentralized finance movement. Indeed, as hype surrounding Olympus pushed the OHM price above $1,300 in mid-October, many investors sold their position in profit, sparking a wider sell-off that sent the price as low as $730 on Oct. 15.
Such price volatility seems at odds with the protocol’s wider long-term goal of serving as a stable asset. However, it is to be expected in this phase of the project. Because OlympusDAO offers more handsome yields to participants when fewer are staking, the protocol encourages renewed participation during such price dips.
However, it would be premature to consider the recent price action a major stress test for the protocol’s game-theoretic assumptions. That can only really come during the future stability phase when treasury growth has slowed and the difference between treasury assets backing each OHM and market price has shrunk considerably. OlympusDAO will likely attract new participants with its large yields ensured by its aggressive expansion — but how it will perform with much lower yields remains to be seen. Additionally, it is unclear how the market would react to a major black swan event.
Compounding these issues are similar protocols that have now adopted similar strategies to OlympusDAO. Projects like Wonderland’s TIME on the Avalanche blockchain offer a massive 59,000% annual percentage yield, as of the time of writing. Given that the primary reason for staker’s involvement in OlympusDAO today is the massive yields offered, competition is surely one of the largest threats to its long-term ambitions.
Smart contracts, price crashes, centralization and regulatory risk
OlympusDAO faces other risks too. While not necessarily unique to the protocol itself, any assessment of its long-term viability would be amiss without their consideration.
As the DAO’s revenue-generation activities expand and incorporate more exotic strategies, the number of smart contract interactions required also grows. Anyone who has spent any time looking closely at the DeFi sector will be well aware of the high-profile exploits that have plagued the still-nascent sector.
While Olympus favors blue-chip DeFi protocols that present much less risk than brand-new, unaudited projects, the threat remains. Take, for example, the recent Compound exploit in which newly shipped code caused massive losses to the protocol. Compound has consistently been one of the most popular and successful DeFi protocols. Yet, even it is not immune to code vulnerabilities.
Xh3 explained how smart contract risk could impact OlympusDAO to OKX Insights:
“Any bit of added complexity entails additional risk and may change the risk profile of backing assets or revenue streams completely. It is also that added risk does not only scale linearly but exponentially. I think we are, therefore, pretty picky with putting excess reserves to work. In fact, the DAO allowed the protocol to put only 33% of excess reserves to work as per OIP-20, which means that the guaranteed backing of OHM should never leave the treasury multi-sig.
For instance, we have over 10 million DAI lent in Aave, which is, as we think, a top-tier protocol and is as safe as it gets for DeFi standards. Let’s pretend Aave gets hacked now, and all DAI deposited there is lost. That would reduce risk-free backing per OHM by a couple of percent but would still guarantee the price floor for OHM as intended. […] Losing a big amount of hard-earned excess reserves would be quite a tragic event. It would maybe even reduce the premium on OHM a bit, though it wouldn’t change the fundamentals of Olympus or OHM.”
Admittedly, the diversification of OlympusDAO’s revenue streams does mitigate the risk somewhat. Should something unexpected happen to one of the protocols it uses to expand its treasury, a single exploit should not have a catastrophic impact on the DAO. Yet, those smart contracts comprising Olympus itself are also theoretically vulnerable, and their exploit could potentially wipe the treasury — i.e., the protocol’s means of paying the yields required to attract participants to support the project — out entirely.
Perhaps a more pressing concern for those investing in Olympus is how centralized the control of treasury funds currently is. At present, a four-of-seven multi-signature Gnosis Safe implementation controls the treasury funds. The Olympus documentation reads:
“The treasury contract is guarded by a four of seven multi-sig. That means any transaction for the treasury must be approved by at least four signers, of which we have seven signers in total. The operation security for our treasury assets is thus protected from a single actor going rogue.”
Yet, four individuals cooperating to potentially profit handsomely is hardly outside the realm of possibility. Several individuals have raised concerns about this centralized implementation, especially those debating a proposed partnership between OlympusDAO and MakerDAO on the latter protocol’s forum. Again, the project is working to reduce this risk by transitioning to greater community control — but, until fully implemented, the threat of an insider “rug-pull” remains.
Posing an additional risk to OlympusDAO and its investors is the threat of an industry-wide market downturn. Despite efforts to diversify its treasury, the crypto assets included continue to exhibit a large degree of correlation with the wider market. The Olympus treasury currently holds DAI, FRAX, SUSHI, LUSD and WETH. Obviously, WETH and SUSHI are vulnerable to market moves, but so too are some of those stablecoins included. For example, DAI still draws around 33% of its collateral from ETH, leaving its backing vulnerable to market forces.
Xh3 acknowledged such risks to OKX Insights, adding that the DAO’s efforts to diversify should somewhat mitigate them:
“The DAO is very much aware that any asset may fail at any moment. This is why we are constantly looking for new reserve assets that we can take into our treasury. It is correct that all the DAI we own has a certain risk attached to it, and so if DAI were to fail right now, then it would be a hell of a disaster for Olympus as well as for most of the protocols being exposed to DAI out there. As of now, DAI has proven to be one of the most risk-minimized stablecoins in DeFi. But that does not stop us from diversifying our treasury further.”
Xh3 went on to explain the challenges of including volatile assets like ETH in the treasury from an accounting perspective. Adding that the plan would be to eventually include greater weight of non-stable crypto assets, they stated that the main hurdle is determining how much of each volatile asset could safely contribute to the funds backing each OHM.
To mitigate the risk of extreme price volatility, MakerDAO opted to increase its stablecoin backing, reducing DAI’s exposure to ETH. This certainly makes DAI — and, by extension, OHM — less vulnerable to crypto volatility. However, it reintroduces exactly the same connections to the traditional financial system that OlympusDAO claims to be leaving behind. Simply put, DAI remains vulnerable to regulatory risk thanks to its significant USDC backing. Consequently, so does OHM.
We asked xh3 to summarize their biggest current concerns with Olympus, to which they responded:
“I think I am most worried about centralization risk. That may come in the form of regulation, which we have great uncertainty about. That may include taxation. Depending on your jurisdiction, it is not clear how a rebase is to be evaluated, and everyone appears to make it differently. Centralization risk does also include dollar tokens to lose peg or most of their value. And then, on-chain governance is something that the DAO can get better on in the future. Having that said, countless Ohmies work super hard behind the scenes to address the issues we can address for ourselves. And then we just have to see how nation-states intend to interpret crypto and DeFi as a whole.
In terms of economic activity and protocol integrations, I am less concerned because we see that engagement has never been higher, and it looks like we are just accelerating from here — also because of initiatives like Olympus Pro. This particular DAO effort shows very strong interest and growth and may change the DeFi game forever.”
OlympusDAO — experimental, fascinating and still high risk
OlympusDAO is one of the more interesting protocols launched during a year in which DeFi has taken something of a backseat to NFT mania. While it has thrived thus far thanks to its enormous yields and seemingly committed community, its game-theoretic assumptions are still to be fully tested — particularly as it attempts to transition from its rapid expansion phase toward more stable prices.
Based on the factors mentioned above, the protocol faces an uphill struggle. As yields diminish and newer protocols based on similar architecture come to market with their own promises of colossal returns, keeping the community from simply cashing out their gains and seeking better opportunities elsewhere will surely be the DAO’s biggest challenge. While it is easy to celebrate the protocol as a success when it is rapidly expanding — and all charts point to the right and upward — true tests will come when growth slows. Compounding these threats are those faced by almost every DeFi protocol. Smart contract, regulatory and centralization risks all pose additional dangers to OlympusDAO.
Ultimately, whether OlympusDAO succeeds or fails, it has already helped to popularize a potential solution to one of the biggest issues facing DeFi today — that of mercenary capital. Its reshaping of the relationship between protocols and their liquidity may well strengthen the sector as a whole. For that alone, history may deem the project a crucial footnote in the evolution of decentralized finance. Meanwhile, time will tell if it is able to achieve its lofty goal of becoming a reserve currency completely detached from the traditional financial system.
