A Legal Engineer’s Guide to a “Fair Launch” ⚖️ 🚀

$YFI Case Study #2 — Fair Food For Food Fights

Big Brains Launch!

Case Study #2 — $YFI — Decentralize in a Week

Enter YFI, “WiFi”, or “What if we just take a smart contract system and give it to the community in a week?”

If $COMP primed the pump on the exit to community strategy, then $YFI was its rocket fuel. The lead developer behind it, Andre Cronje, has been building smart contracts and DeFi tools in Ethereum for awhile. There have been strategies such as “yield bouncers”, flash transactions, and leveraged collateral positions. Interesting and exponentially useful middleware strategies become possible in a world where the contracts built on the Ethereum commons such as Uniswap, Maker and Aave are permissionless (meaning anyone can access them to build on them). To highlight just one strategy, by way of example, we will dig into “yield bouncers”.

What is a “Yield Bouncer”?

To understand yield bouncers, it might be illustrative to use a traditional banking relationship. Obviously the banking industry is heavily regulated and its risk profile cannot and should not be compared to DeFi. Let’s say that a fellow saunters to a local bank and deposits rainy day fund. The bank normally pays a rate of interest. Assume the bank offered a teaser rate of 1% interest for 6 months. Now imagine that the teaser has expired and you see that Chase bank has a teaser rate down the street for 1.25%. In order to take advantage of this, one needs to walk into the bank, withdraw funds, close the account, meet with an account specialist, etc. Then go and open the new account. Yield farming in the real world sounds like a full time job.

Now imagine a world where a financial application sits in the middle scanning for various lending opportunities and through programmable smart logic is able to bounce the deposit from one bank to the next to take advantage of the opportunity. The application only does this when the benefit of moving it is greater than the friction involved with the transfer. Now also imagine, that not only can it bounce between banks searching for yield. It can also bounce between a curated list of currencies. So, maybe the Canadian Dollar is offering higher yield versus USD, versus AUD. Also, imagine that it doesn’t discriminate based on deposit size. So it bounces the $50 deposit the same as a $5,000 deposit. In other words, it is a yield shark, pooling capital, and searching for the best opportunity based on the strategy. Yield bouncing is the type of DeFi strategy that is not really possible in a permissioned system behind legacy banking infrastructure.

There are risks (which won’t be fleshed out completely), but obviously in a DeFi stablecoin world, the yield bouncer is only as good as its worst collateral and its worst lending protocol. If it bounces to a lending protocol that has a hole in it, it could theoretically suck the liquidity through the hole. There is not FDIC insured deposits, probably very little actionable recourse, etc.

So with this rudimentary understanding of yield bouncers, we next explore $YFI. The lead developer, Andre Cronje, of the iearn system named “yearn” created a $YFI protocol governance token for the Yearn system, and with that token pass control, ownership and governance of the entire yearn.finance suite of tools, and smart contracts to the token holders. Despite having the power to give himself a token pre-mine or founder reward, he elected instead to keep zero tokens for himself. This was the “birth” of a “Fairness Launch” that anyone can stake in the system and share in the risk and reward of bootstrapping the protocol.

The fairness is an important concept to flesh out as one of the reasons for protections under securities regulations is to insure that insiders and early stakeholders aren’t raising money from later investors using misleading information and then dumping the investment on these poor saps. How to deal with asymmetric information and advantages? Enter a free for all yield farming experiment.

Yield Farming and Fair Launch

What does yield farming look like in practice? As mentioned earlier, the “Yearn” system is a yield bouncer. To make it efficient it makes sense to attract capital at scale and regularly. Why? For the yield to “bounce” the smart contract requires someone new to interact with the state of the contract. In other words, nothing bounces until the smart contract is called to bounce to the higher yielding opportunity. So as the Yearn system attracts users, those users are responsible when they join the pool for paying the gas to “bounce” the yield.

For its tokenized fair launch, $YFI targeted users of its liquidity pools to stake their liquidity tokens and earn $YFI proportionally over time (in $YFI case a week). This is often called Pool #1 staking. The staked liquidity is used to “liquidity mine” and reward liquidity providers for doing the work and participating in the protocol. As pioneers, the users of the protocol are rewarded with the governance of the protocol and the right to make changes to the protocol. Once the Pool #1 token (YFI) is out in the wild and claimed, then the “Yearn” fair launch began to incentivize Pool #2 which is to add liquidity to the token itself through offering $YFI rewards for $YFI trading pairs with other more liquid tokens. For a much more in depth discussion of the one week $YFI farm system refer to Weeb McGee’s medium post on YFI yield farming. But put simply, if yield farmers make the trading pair liquid (which means offering a more liquid token to a trading pair, for example ETH or Stablecoin) then they are rewarded with additional $YFI for the risk. The risk is that if the $YFI token launch fails, then the yield farmer will end up with a much larger number of $YFI tokens as the pair trades the ETH for $YFI on the way down to balance the pair.

Is liquidity mining “fair” like Bitcoin mining was?

An inevitable comparison arises with liquidity mining and bitcoin mining and which is “fairer”. In Bitcoin mining, people invested and directed their computer, hash power, electricity, etc. to shout algorithms into the abyss to earn Bitcoin. Anyone can do it, especially at first. Now it is a whales game with entire bitcoin mining operations hitched with hydropower and tomato farms using excess heat. Similarly with $YFI liquidity mining the early entrants could earn a much larger proportion of the rewards with less yCRV tokens staked. As the idea caught on and word spread the amount staked in the yCRV system grew faster than Covid at Lake Havasu. The liquidity farmers spend time and Ether in the form of “gas” to enter the Yearn smart contract system, and stake the liquidity token to earn $YFI. It is almost like a mechanical turk versus the bitcoin proof of work.

Is tokenized governance a thing?

In other words, do people really liquidity mine to earn a greater say in the protocol? Yes and no. Some “yield farmers” are clearly liquidity mining and market selling as fast as they can mine. Others are clearly interested in building a say in the community and are in it for the long-term. It is early days, but governance of decentralized protocols through token ownership is worth watching. For example, want to offer a new stablecoin or have a community manager? Offer a proposal and have the token governors vote. For the current state of voting, check out gasless voting on “SnapShot”

To forge a decentralized community doesn’t require only self selected dai-hard $YFI fanatics to liquidity mine. With the short time frame of one week, the $YFI liquidity mine allowed a rapid sorting and price discovery. Many dropped into the community, became involved, started building, and decided that they would acquire even more $YFI as true believers. So even market dumpers play a role in distributing the protocol by market dumps to those with a more long-term perspective. With this, $YFI has had a very favorable supply distribution, quickly bootstrapping liquidity and a decentralized community. Participants were on equal footing (as far as each $ risked) with everyone that earned tokens having undertaken the same risks with all the information freely available to them. As mentioned earlier the $YFI launch is reminiscent of early Bitcoin mining, as nobody had a head start–not even the developer, and the only way to acquire it was to earn (mine) it. Much like early bitcoin miners, early YFI yield farmers have self-selected as those most in tune with DeFi, ensuring a passionate and involved community. Quick decentralization of a minimally viable protocol allows the protocol to acquire users, developers and ecosystem quickly with incentivized ownership in protocol. Fail fast.

Protocol Governance at Work

One noteworthy development is that the community can decide how to fund future development of the protocol. If the vote is deemed unfair. Then fork and see if the community follows. Additionally, the Cambrian explosion of protocols also enables one protocol to vote to award and build future ecosystem commons. MolochDao v1 was a DAO that was developed to provide grants and funding for the “Ethereum Commons” as a nonprofit DAO Ostensibly, to support development in protocols that were not of interest or arguably unfunded by the larger Ethereum Foundation. YFI has become a beast in its short life with the $YFI community agreeing to award earned funds to support infrastructure and Ethereum development. Here the YFI community voted to provide funding for gitcoin grants.

Yearning for Grants

Security Blanket

The amazing thing with the wacky YFI launch structure and Andre Cronje trusting the process and open sourcing the project is that it worked! Few Understood! Left in the wake of the YFI launch are a litany of naysayers and befuddled lawyers, and venture capital investors. YFI has recently joined the three comma club with over 1 billion in notional US value market cap and is officially listed on Coinbase Pro. The “Coinbase effect” is a soft signal that Coinbase has presumably performed some diligence and had their high falutin’ attorneys review the token model for securities issues. Point being that the project went from code to Coinbase in a few months.

Are these principles enough?

It should also be said that there is explicitly no guarantee that regulators (or private parties) won’t initiate lawsuits and seek redress against $YFI as an unregistered security. Sufficient decentralization isn’t a bright line test. It is nigh impossible to prove that a tokenized decentralized doodad isn’t a security without registration. The SEC can provide guidance, and safe harbors, and a body of case law, but overall how these “fair launches” are regulated will fall into the prosecutorial discretion of the SEC and the courts that would ultimately be the final arbiter. Or obviously to the other rule making authority of the land, Congress.

The last guy waiting for Congress to clear up regulatory confusion

Greed is Good?

One downside of yield farming as a human and capital coordination system is whether human nature and greed lead down the same dark path as traditional laws and regulations are meant to harness and temper. Andre Cronje now refers to the liquidity providers as liquidity locusts. Basically when they are done farming, they dump on the community and leave barren waste behind. With any “get rich quick” ideology, first money then greed and charlatans soon follow.

Special thanks to Adam J Kerpelman for providing comments. Next case study to follow will be YAMS, stay tuned…..

All links provided are for informational purposes only and not meant as recommendations of the people or products. Nothing herein is legal advice and should not be relied upon without reaching out to your own personal attorney. The linked ABA disclaimer is appended to the blog.

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To be continued…..