DeFi Protocol Bancor pauses impermanent loss protection feature in the midst of liquidity crisis

Prominent DeFi protocol Bancor suspended its Impermanent Loss Protection program, citing “hostile market conditions” and “manipulative behavior” as the main causes behind the action. Assuring users and investors that it’s only a temporary measure, Bancor noted that all funds on the protocol are secure, and trading remains active on all liquidity pools.

Impermanent Loss

Many DeFi protocols have entered crisis mode as liquidity strains and investors withdrawing funds from liquidity pools have resulted in a prolonged selloff that has not reversed.

Following that crypto lender Celsius froze users’ accounts last week, decentralized automated market maker (AMM) – Bancor – announced, on Monday, halting its Impermanent Loss (IL) Protection feature designed to offset the impact of IL by distributing its native token BNT to those affected.

IL in DeFi occurs when the market conditions outside of DeFi cause the initial value of staked assets to change relative to its deposit value. The protocol was refined when it launched Bancor Version 3 earlier in the year. This made it stand out from other DeFi competitors.

According to the official blog post, the bold measure aiming to “protect the protocol and its users from potentially manipulative actors” will be lifted once the market stabilizes again. The protocol didn’t give a time frame for this extreme measure.

The decentralized exchange provided comfort to its users by allowing them to continue receiving yields on staked assets and withdraw funds with IL coverage once the feature has been reactivated. The statement reads:

“Withdrawals performed during this unstable period will not be eligible for IL protection. Users who remain in the protocol will continue earning yields and be entitled to withdraw their fully-protected value when IL protection is reactivated…

Deposits are currently not accepted to prevent confusion via direct contract interaction where the information on paused protection is not visible.”

Selling Pressure

The abrupt change of policies came as a response to the rewarded BNT getting consistently dumped in the past 18 months, leading the asset’s price to slump. BNT trades at $0.53 right now, which is 95% lower than its 2021 peak.

The team suspended the feature to stop BNT plunging. This has to do with IL compensations in BNT to users, increasing the supply of such an asset and thus facilitating the token’s price decline. In addition, the team cited “the recent insolvency of two large centralized entities who were key beneficiaries of BNT liquidity mining rewards” as partly responsible for exacerbating the situation:

“To cover their liabilities, these entities have rapidly liquidated their BNT positions and withdrawn large sums of liquidity from the system, while an unknown entity has opened a large short position on the BNT token on an external exchange.”

Liquidity crisis

Prior to Bancor’s latest move safeguarding its native token, Babel Finance had already joined Celsius in pausing withdrawals due to liquidity pressure. The crypto industry is experiencing the worst selloffs since years. Some firms are having difficulty financing their loans and liquidations have occurred to renowned digital asset hedge funds, Three Arrow Capital (3AC).

In Bancor’s case, the protocol said it had identified “anomalies” through its on-chain data, suggesting that more than one major participant has been actively shorting the token.

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