Explained: Solend DAO’s whale wars and DeFi lending drama

Amid a brutal repricing for crypto, Solana-based (SOL) DeFi lending protocol Solend DAO (SLND), found itself at the center of several potentially existential crises this past weekend.

After revealing that a single ‘whale’ had gained a near-monopoly on two of the protocol’s available lending assets, risking a potential crash of its underlying SOL / SLND ecosystems, a vote gave Solend DAO the authority to seize the whale’s holdings before another vote invalidated this authority, leaving the DeFi lender in limbo.

Welcome to another crazy day in DAOs.

Problem 1: Unlimited borrowing creates risks, apparently

On Sunday, Solend Labs posted its first governance proposal, titled “SLND1: Mitigate Risk From Whale.” The proposal informed the community that a single customer had assembled an “extremely large” margin position that was “putting Solend protocol and its users at risk.”

The proposal also warned that the anonymous user had deposited 5.7 million SOL tokens to use as collateral for borrowing $108 million worth of Tether (USDT) and Circle (USDC) stablecoins. According to the posting, these positions amount to 95% of all SOL deposited and 88% of all USDC borrowed from their main asset pool – a staggering 25% of the Total Value Locked (TVL) on the platform.

Using the protocol’s parameters, the proposal calculated that if the price of SOL were to drop to $22.30, 20% of the user’s ‘borrows’ would be liquidatable, or about $21 million worth of SOL. As explained by the post, a liquidation of this size could not readily be absorbed by the market and SOL could experience significant price declines.

Problem 2: Solend DAO users head for the exits, trap others inside

Concerns regarding the risk of this single massive loan going bad have caused many other users to withdraw their assets – leaving the “utilization” of USDC and USDT to jump to 100%. This exodus leaves nothing for the rest of their depositors to withdraw. Worse, other positions that used USDT or USDC as collateral now cannot be liquidated.

A run on the bank had partially begun.

Solend now faces the possibility of being saddled with bad debt that exceeds its assets and currently cannot provide customers the withdrawal ability they are entitled to — what we traditionally refer to as insolvency.

Problem 3: Ghosting whales rock the boat — decentralized risks, centralized beneficiaries

The proposal further detailed the ‘decentralized’ lenders’ unsuccessful attempts to contact the “whale” since June 13.

Since the liquidity issue began, the automated interest rate mechanism used by the DAO has pushed USDC and USDT APY rates to their maximums of >60% and >600%, respectively. Unless the whale wants to play ball or Solend can find an outside party to provide it with an additional stablecoin supply, the DAO cannot, through any current mechanism, respond to the unfavorable USDC and USDT dynamics.

Solend DAO’s devs revealed that they had already been in conversation with market makers and automated market makers (AMMs). These are essentially competitors of Solend, offering the same services for different tokens, ecosystems, etc.

The stated objective of these conversations is to attempt to determine a method to incentivize customers to deposit more stablecoins on the platform and to arrange some procedure to allow the potential forced liquidation to occur without wreaking havoc on token prices and the SOL network.

Solution: Solend DAO proposes solutions

Sunday’s governance proposal offered a two-pronged approach to addressing the brewing crisis:

Retroactively enact a new policy for large borrowers to de-risk the current whale’s margin position.
Grant Solend Labs “emergency power” to seize the large account to forcibly liquidate it in a pre-arranged manner in cooperation with outside partners.

Barely more than 1% of the total population of token holders participated in this vote and it passed after a single large account contributed more than 98% of the “Yes” votes.

This “democratic” vote, secured by a single voter, to seize the assets of another single user, which were to be handed over to a still-anonymous development team, raised alarms with Solend’s community, generated SOL headlines all weekend, and cast a significant shadow over the veracity and feasibility of accomplishing DeFi’s central aspiration: true “decentralization.”

Epilogue to this episode

Hours later another vote was held. Proposal SLND2 was passed — invalidating the previous emergency powers vote and increasing the voting time for future proposals to 24 hours. Interestingly this rescinding vote also won the support of the million-vote wallet that passed the initial emergency powers proposal.

Over the course of the next day, SOL prices reversed their precipitous declines. Solend now had headroom to operate and a buffer for the potentially nuclear margin call. So the team proposed yet another solution: lending limits.

Considering a strategy used by virtually all non-criminal financial institutions for most of modern history, Solend DAO has proposed capping the amount that any user can borrow from the protocol and decreasing the maximum liquidation amount for margin-called accounts from 20% of holdings to 1%.

If it is passed (voting was 99.7% in favor at press time, 67% of which was contributed by the same large voter as in previous votes) Proposal 3 will immediately enact rolling, per-account liquidations of positions that exceed its proposed $50 million limit on individual accounts.

The Solend DAO team acknowledged there was no way for this new policy to address individual users splitting their positions across multiple accounts to circumvent the new policy — but stated that “this problem can be addressed in the future.”

The ongoing saga of the Solend DAO illustrates just one of the litany of thorny issues presented by the nebulous and largely unregulated nature of DAOs.

DAOs only work as well as they’re programmed

Decentralized Autonomous Organizations (DAOs) were initially proposed as an efficient and secure solution to improve democratic decision-making, transparency, fairness, access, and innovation in business, investing, and finance. From the very start, this has proven to be much more aspirational than achievable — the reasons for this are myriad.

A DAO is, at its heart, software that employs a voting input mechanism to determine decision making and automate the execution of transactions on irreversible blockchain ledgers which store the records of these transactions.

So any error, bug, loophole, or otherwise, that makes it into the software when it is launched will invariably be reflected in the ‘immutable ledger’ of transactions, irrespective of the wishes and intentions of its creators or participants.

“The DAO,” the framework’s namesake, was heralded as the birth of the new internet and the new economy well before “web3” found its way into the lexicon.
- Founded in April 2016 and envisioned as an automated, democratic VC firm that would invest in other blockchain projects at the behest of its participants, the DAO immediately became one of the largest holders of ETH in the world amassing $120 million in its first few weeks.
- In June of 2016, a user discovered that the DAO code would allow repeated withdrawals of ETH before updating balance totals — this resulted in $50 million worth of ETH being siphoned by users.
- Ultimately, the Ethereum blockchain itself was forked to allow a forced transfer of the siphoned assets, splitting the community and undermining the fundamental philosophy of the underlying technology.
In another code-level mistake a DAO named bZx featured programming written such that it was twice subject to simple phishing attacks, leading to millions of lost tokens, even more in USD value out the door, and a very angry group of token holders suing.

Inside a DAO “Code is Law” — but it isn’t anywhere else

While evangelists will regale any who would listen with the well-worn (and legally meritless) axiom “Code is Law,” … unless and until everything else the DAO interacts with exists entirely in cyberspace this isn’t a helpful framework for understanding DAOs.

Each DAO has different internal governing structures, some are actually Wyoming-based LLCs, where legislators have created a simple on-ramp for DAOs to structure themselves. Many more are unofficial, unregulated operations that, depending on the jurisdiction they interact with, may be considered general partnerships, or even illegal schemes.

Nothing changes the fact that all DAOs, by virtue of interacting eventually with real humans, are subject to an ambiguous and often contradictory patchwork of international, national, and local regulatory frameworks — depending on what activities the DAO is engaged in and where the humans engaging with it reside.

In 2017, in the wake of the failure of The DAO the SEC issued an investigative report finding that the DAO tokens issued by the blockchain project were, in fact, unregistered securities sold in an illegal offering.
In November 2021 the SEC instituted proceedings against Wyoming-based American CryptoFed DAO for filing deficient and misleading registration and disclosure documents in anticipation of its token distribution.
Simple Agreements for Future Tokens (SAFT) is a fundraising method that seeks to emulate equity fundraising, insulating DAO investment capital from the distribution of governance tokens, in an attempt to avoid the issues of unregistered securities offerings.
- In Sept 2020 a federal judge ruled, for the second time in the Southern District of New York, that the two-step SAFT framework does not necessarily distinguish DAO tokens from illegal securities offerings, and rendered a summary judgment against Kik Interactive Inc., in favor of the SEC which sought to enforce relevant securities laws.

Without balancing competing interests DAO ‘democracy’ is just mob rule

Solend is not the only DAO to contend with the dilemma posed by ‘whales’ creating risks that only centralized responses and disenfranchisement can solve. Similar to the issue faced by Solend, a single Juno Network user accumulating an outsized proportion of the value and influence within a DAO immediately created risks that undermined the operation and economics of the autonomous project.

In early 2022, The Juno Network voted to remove over 3 million tokens from a whale, accusing the token holder of gaming an airdrop to accumulate more than the fair share of tokens.
- Rather than a smooth process following the debate and headlines created by Juno Networks’ proposal to revoke a user’s assets — a programming error in the revocation process ended up sending the confiscated tokens to a random wallet to which, apparently, no one has access.

There is no recourse — all DAO votes are final, maybe

While the members of a DAO and its developers, backers, and promoters may make high-minded claims about democracy, power, voting, ownership, smart contracts, and terms of art, the reality is that these concepts are only applicable within the framework of the DAO itself, as the rules of a digital game.

The connections between the DAO and the human citizens with which it interacts are still governed by the incumbent authorities, as they will be for the foreseeable future.

Asked about the power of voting to overrule externally applied contractual obligations, crypto-specialist attorney Grant Gulovsen told Protos “a DAO voting to retroactively change the terms of a contract typically won’t have any legal effect on the terms or the enforceability of the original contract terms unless the original contract explicitly allowed for that to happen.”

When Merit Circle DAO decided they didn’t like their existing investor mix, they decided, via vote, to simply pay out one of their founding investors YGG on a 1:1 basis, instead of the 30x payout that YGG was contractually owed.
- Merit argued that YGG was a competitor and was not bringing value to the DAO, so, therefore, they voted them off the island, essentially.
- YGG and their lawyers did not take kindly to this, unsurprisingly, and threatened lawsuits.
- The case, as of June 15, seems to have been settled by YGG agreeing to take a 300% cut on their expected return.

Solend DAO post mortem

In theory, the DAO is the most highly evolved organism within the sovereign citizens’ libertarian fever dream. A financial organization that is boundaryless and ownerless, existing beyond government oversight, managerial discretion, or any central authority and controlled autonomously in cyberspace by the anonymous voters who hold tokens it self-manifests.

In reality, a DAO is a software machine that uses voting to distribute digital tokens and uses digital tokens to assign voting power. It does this in furtherance of whatever goal is set out for it, parameterized largely by the interplay of real economics and game theory and determined entirely by the quality and content of its programming.

And as the very first DAO participants discovered — immutable, democratic, and autonomous activities are all noble ideals until it’s time to split the check or fix an error. Then reality sets in and the lawyers start sending bills.

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