DeFi-ning New Developments: Chainalysis Adds Coverage for Governance Tokens and Cross-chain Bridges

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Chainalysis recently added advanced investigation and compliance support for six more popular ERC-20 tokens. All six tokens are DeFi related and five of them specifically belong to top DeFi protocols. 

Collectively the six new tokens had more than $155 billion of trading volume in the second quarter of 2021, representing 1.4% of all crypto trading. They are:

  • AAVE: The governance token of Aave, a decentralized lending protocol. It allows users to borrow assets and earn interest on deposits. They also offer uncollateralized flash loans.
  • CRV:  The governance token of Curve Finance, a decentralized exchange (DEX) optimised for efficient stable coin trading. 
  • renBTC:  An ERC-20 token pegged to the price of Bitcoin. Through a bridge between the two blockchains, it allows the permissionless transfer of BTC to and from Ethereum for use in decentralized applications.
  • UNI:  The governance token of Uniswap, a decentralized exchange and currently the biggest DEX.
  • SUSHI:  The governance token of SushiSwap, a decentralized exchange. SushiSwap began as a fork of Uniswap.
  • YFI:  The governance token of yEarn.finance, a decentralized asset management platform. It offers yield farming strategies that aim to automatically maximize users’ yield, as well as other services including liquidity provision, lending and insurance.

The growth in DeFi usage has been one of the major crypto trends of the past year. In July 2020, DeFi protocols collectively held $1.8 billion of assets. That figure began to grow quickly in August, and now, as of July 2021, consistently stands above $60 billion of total value locked in DeFi. As DeFi usage grows, it's important that providers like Chainalysis adapt accordingly so that DeFi transactions can be carried out as safely as those in the centralized cryptocurrency ecosystem.

What are DeFi governance tokens?

Five of the six new tokens we've added support for are governance tokens for popular DeFi protocols. But what does that actually mean?

The core idea of decentralized finance is enabling financial services purely through code run on a distributed blockchain. Through carefully designed smart contracts, DeFi protocols bring together users and investors and automatically control funds, doing the necessary coordination required for a financial service to operate. Due to the security and immutability of the underlying blockchain, the protocol smart contracts can’t be edited, stopped, or taken down, unless they’ve been specifically designed to allow changes.

Of course, a DeFi protocol shouldn’t let just anyone change the underlying smart contracts as they please, as this could allow the protocol to be hacked and for users’ funds to be stolen. At the same time it may not be ideal to prevent all changes; bugs and vulnerabilities get discovered, improvements are developed, and new opportunities to grow the market appear. 

A select group of individuals or an organization could permanently be given permission to make changes to the smart contracts, but this goes against the philosophy of decentralization. That's where governance tokens come into play.  

DeFi protocols issue governance tokens to users and project backers. The tokens vary in the exact powers and utility they provide to the holder, but nearly all provide the power to propose and vote on changes to the associated DeFi protocol. This works much like shareholder votes, with code changes or fund distributions put forward to be voted on and potentially enacted on-chain. Each governance token gives the holder a specific number of votes. The more tokens you hold, the more votes you get. 

Different protocols allow different levels of flexibility in the changes possible but can include things like changing financial variables, adding new features, blacklisting certain users, repairing vulnerabilities, distributing fees, spending development funds, and more. 

Usually some of the governance tokens are set aside on launch for the initial project backers such as the development team and investors, similar to startup equity. However, most of the remaining tokens are distributed publicly based on usage of the DeFi protocol, a bit like a rewards program. They’re not exclusively distributed to liquidity providers, as users of the service can receive them as well. Each time you do a swap on a DEX or act as a liquidity provider, you can earn governance tokens. This gives power to those who use the protocol most and incentivizes them to continue using it. 

Some of the other common features added to governance tokens include:

  • Requiring holding or spending of governance tokens in order to use the protocol, e.g. to pay fees or as liquidity
  • Discounts or improved rates for holders
  • A share of the profits earned by the protocol
  • Staking to provide additional security or insurance
  • Access to additional features or services

The voting rights and features like the above can give governance tokens value. Moreover, like nearly everything in crypto, governance tokens can be traded. As the usage of DeFi protocols has grown, so has the popularity of trading their tokens. Users who aren’t so interested in the governance of the protocol can earn tokens as they use the protocol and then sell them. The value of governance tokens can therefore work like a rewards scheme, giving financial incentive to use the protocol. This brings in more users and funds, helping grow the protocol’s market share. Increased users and liquidity often improves prices and reduces slippage, bringing in more users and creating a virtuous cycle. Depending on the price of the governance token, you can actually be rewarded for taking out a loan!

Most DeFi projects are started by a small core team of developers. They will start with a lot of control over the project via access to the underlying smart contracts. The goal of many of these projects is to gradually decentralize over time as they grow, giving more and more power to the governance token holders, until control of the project is eventually entirely in the hands of a Decentralized Autonomous Organization (DAO).

There are risks along the path of decentralization, many of which are reminiscent of the myriad of shareholder shenanigans that have taken place in traditional finance over the years. However, some of these risks are unique to crypto, such as flash loan attacks. It’s not clear yet how to balance the leeway governance votes should be given in order to respond quickly to crises and give enough flexibility for growth without also opening up to unintended consequences. The stakes will rise as more value is controlled by DeFi protocols and there are increasing incentives to manipulate and exploit their governance.

Cross-chain bridges

Another recent trend in crypto is the increase in the number of new blockchains being launched. This is particularly noticeable in comparison to the last bull run, when it was mainly just new tokens being launched. On top of this, there is an increase in scaling solutions such as sidechains, layer two protocols, and sharding or parachains.

All of this means even more varied distributed ledgers to support cryptocurrencies, each with their own characteristics and functionalities. It’s natural for cryptocurrencies holders to want to move their assets across blockchains.

Since the early days of crypto, exchanges have offered the possibility to swap between different blockchains’ assets. Pegged token issuers have also offered tokens that are matched one-to-one to other assets on and off-chain. For better or worse, these have relied on centralized services to facilitate cross-chain activity. A new type of protocol known as a cross-chain bridge has made it possible for users to move assets across different blockchains without using a centralized service.

The cross-chain bridge works a bit like a decentralized stablecoin, with its own contract to govern transfers:

  1. A user sends an amount of cryptocurrency “X” to an address controlled by the bridge. Let’s say 10X.
  2. The 10X of cryptocurrency is automatically locked up in that address. A signal is then sent to a smart contract on the other blockchain, “Y”, often via an oracle. 
  3. The cross-chain bridge smart contract on chain Y mints 10 “X tokens” and sends them to an address controlled by the user.
  4. The user can do what they like with the X tokens on blockchain Y. Due to the bridge, their value is designed to remain pegged to the value of cryptocurrency X.
  5. If they like, the user (or whoever holds the tokens now) can send ≦10 of the tokens back to the bridge to redeem back on blockchain X. Let’s say they want to send 3X back to blockchain X.
  6. The process is reversed with 3 tokens being burnt and proof of burning communicated to the bridge address back on blockchain X.
  7. This proof of burning releases the locked up funds worth 3 of cryptocurrency X to be controlled by the user again.
  8. The bridge uses clever encryption that requires proof that the necessary on-chain activity has actually occurred in order to lock/mint and burn/unlock the funds on each chain. This ensures that the total outstanding pegged tokens on one blockchain are backed one to one to the locked funds on the other blockchain.

RenBTC is one of the tokens of RenVM, a virtual machine created to bridge different blockchains and enable interoperability between them. Following a process similar to above, it offers users the ability to move multiple cryptocurrencies across the different underlying blockchains in an automatic and permissionless way.

These cross chain bridges can be valuable for the cryptocurrency ecosystem, as they enable flexibility so that cryptocurrency holders aren’t limited to the capabilities of each chain. One of the most popular of these is Bitcoin running on the Ethereum blockchain for use in DeFi. Users also don’t need to rely on centralized services to move their Bitcoin to Ethereum, or trust that their pegged tokens are actually backed one-to-one, since that information can be observed and confirmed directly on-chain.

Unfortunately, cross-chain bridges also provide more cash-out options for money launderers as well as opportunities for those who wish to obfuscate their illicit activity. Due to the permissionless nature of these bridges, tainted funds can be moved across multiple chains, an obfuscation technique known as chain-hopping. 

We’ve already seen this type of cross chain bridge used for the laundering of stolen funds, and it’s a pattern we expect to see grow. By adding support for renBTC, and other cross-chain bridge tokens in the future, we can help mitigate this criminal activity and ensure cross-chain transfers are carried out safely.

Chainalysis and DeFi

Chainalysis’ mission is to build trust in blockchains. We do this through transparency. Unlike traditional financial services or centralised cryptocurrency services, DeFi is completely transparent by default. All activity is recorded on-chain, and thanks to the underlying smart contracts, the exact steps the protocol takes providing its service, and all the addresses involved to do so, are public. This transparency, aided by Chainalysis, enables end users, participating companies, investors, and government agencies to have a deep understanding of what’s going on in DeFi and the value involved, as well as evaluate and respond to illicit activity.

DeFi is a major innovation in financial services and has the potential to become hugely impactful as it becomes more mainstream. For DeFi protocols to be both well-governed and decentralized, trust and transparency are vital. That’s why we believe that blockchain analysis will be key to the success of DeFi.

That also applies to cross-chain bridges. In our training programs we teach investigators how to follow chain hopping and track down illicit actors using multiple blockchains to obfuscate their activity.

Our product support for DeFi will continue to expand as we continue investing in extending our blockchain support, as well as improving our tools for more advanced protocol and smart contract analysis.

Contact us here to find out more about how Chainalysis can help you understand DeFi activity.

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