Learn how Shade Protocol builds a privacy DeFi ecosystem

Author: RainandCoffee/mikey

What is Secret Network

Secret Network is a public blockchain with privacy-preserving smart contracts. Most blockchains that support smart contracts are public by default, meaning that the data used in their smart contracts is open.

While the public record of blockchain data has several advantages, such as ease of auditing and tracking, visible smart contract terms (i.e., allowing users to view the contents of a smart contract before signing or interacting with it), and the ability for public scrutiny, privacy-preserving smart contracts still play a crucial role.

Secret Network adapts traditional smart contracts by supporting encrypted inputs, encrypted outputs, and encrypted states—providing data privacy for sensitive information stored on the blockchain. It is important to note that the native token of Secret Network, SCRT, is public (SCRT token transactions are visible on its public blockchain).

In contrast, the privacy-preserving Secret token (i.e., sSCRT) is encrypted by default to ensure anonymity and confidentiality. These sSCRT tokens require a "view key" to access their sensitive data, and the "view key" is controlled by the user, who can share it with others. This allows users and developers to maintain control over their data and decide what to share and with whom.

This sounds interesting, so how does it work?

Secret Network is built on the L1 Tendermint blockchain using the Cosmos SDK, and it can connect to other public blockchains in the Cosmos ecosystem via IBC. One of the key features of Secret Network is its ability to achieve data privacy. This is accomplished through three key technologies—key management, encryption protocols, and Trusted Execution Environments (TEE), all of which must be supported by all validating nodes.

The TEE (Trusted Execution Environment) is used to hide data within the network. Secret does not rely on specific organizations to manage private data but instead depends on a decentralized network of secure processors. Each node operator is equipped with specialized hardware that allows them to run code within "secure enclaves." No one, including the node operators, can access the raw information being decrypted and processed.

This can only be achieved by wrapping tokens into privacy-equivalent tokens (SNIP-20) through Secret contracts.

Secret contracts allow for the execution of encrypted inputs, states, and outputs, enabling messages and data to be encrypted by users. Due to the TEE, only the transaction sender and the contract itself know the encrypted outputs.

This leads to a unique opportunity for Secret Network—programmable privacy.

For cryptocurrency to gain mainstream acceptance, our daily transactions and activities need a certain degree of privacy.

It is hard to imagine that in the future, individuals (or organizations) will be satisfied with anyone being able to see their wallet purchase activities. Similarly, the ability to control who can view these privacy tokens is necessary for compliance in a blockchain-driven financial world.

The most important reason why privacy should be a right is that it enables individuals to determine what our information is used for and how it is processed, especially concerning large corporations. Therefore, controlling your privacy allows us to maintain our autonomy securely and confidentially.

Thus, let us introduce the focus of this article—Shade Protocol and its algorithmic stablecoin, Silk.

What is Shade Protocol?

Shade Protocol is a series of interconnected, privacy-protecting decentralized financial applications.

So what problem does Shade Protocol solve? What makes it unique?

If you have been in the DeFi space for a long time, you will notice a common trend among new protocols. When a new platform gains public attention, a set of core universal decentralized applications (Dapps) typically follows, usually including:

1. Stablecoins;
2. Synthetic assets;
3. Insurance;
4. Lending;
5. Decentralized exchanges (DEX);
6. Others;

Each protocol needs these core DeFi Dapps to effectively serve as financial services. When these DeFi Dapps first launched on Ethereum, they were innovative, but now they have become the standard. From the perspective of blockchain developers, the issue is that each new Dapp has its own native token. This often leads to distractions, inefficiencies, and increased opportunity costs due to the lack of a cohesive and interconnected DeFi Dapp ecosystem. Shade Protocol aims to address this issue by establishing a set of connected privacy-preserving DeFi applications.

What does this mean?

Instead of each new application creating a new token, the Shade Dapp application suite only issues one universal governance token, with each Dapp sharing a treasury and adding value for Shade token stakers. Additionally, all Dapp protocols are connected to the same Shade Protocol website portal, greatly simplifying the DeFi user experience. Remember, our goal is to make DeFi accessible to everyone, not just crypto natives.

So what is the first Dapp based on Shade Protocol?

Silk! Let’s take a look at what makes it special.

Silk Privacy Algorithmic Stablecoin

Silk is the world’s first native privacy-preserving burn algorithmic stablecoin backed by a basket of global currencies and commodities.

This description is long and convoluted, so what does it actually mean?

First, we need to understand the evolution of stablecoins.

While Tether is useful in addressing liquidity issues, it brings a key problem to blockchain (i.e., lack of decentralization). The creation of DAI was to solve this centralization issue (although it is still relatively centralized).

However, DAI also brought its unique problems, as during contraction (and sometimes expansion) market events (i.e., market volatility), when the collateral backing DAI (primarily ETH) is liquidated, DAI can become unpegged from the dollar.

The algorithmic pegging design of TerraUSD allows for real-time dynamic adjustments to market forces, enabling it to better maintain its peg during market fluctuations. Although TerraUSD was successful, it did include inflation mechanisms and lacked transaction privacy.

Thus, the goal of Shade Protocol is to create a privacy-preserving stablecoin that incorporates mechanisms similar to TerraUSD but without the added inflation mechanisms. This stablecoin is called Silk.

So what makes Silk special?

1. Silk is pegged to a basket of global currencies and commodities rather than being tied to a sovereign currency (i.e., the dollar) that is prone to inflation. According to Shade, this will make Silk the most stable currency ever. This is important because it allows users to better maintain purchasing power and protect against the negative effects of inflation and volatility.
2. Silk also has a unique tokenomics structure (see below).
3. Additionally, Silk can protect privacy, meaning users can control who can view their sensitive financial data.
4. Finally, Silk will also interoperate with other IBC blockchains (such as Atom, Juno, and Osmosis).

Dual Tokenomics

One of the most important factors to consider when analyzing new crypto protocols is the project's tokenomics. The tokenomics of a project has the power to determine the future of the protocol, and healthy tokenomics allows token holders to appreciate in value while ensuring the protocol maintains a long-term vision.

Conversely, poor tokenomics doom a protocol to a slow death. So how does Shade's tokenomics stack up? Let’s take a closer look at the dual tokenomics of $SHD and $SILK.

1. Shade ($SHD) Token

SHD will serve as the governance token of Shade Protocol, and the amount of SHD held will determine voting power on governance proposals.

The SHD token has intrinsic value as it is used to mint/burn Silk tokens.

Shade Protocol aims to create various other financial products, and the SHD token will play a key role in this financial product suite.

The SHD token will also help manage ShadeDAO, which in turn manages its treasury. The balance sheet controlled by Shade Protocol governance will be used to stabilize the value of Silk while generating sustainable returns for SHD stakers.

Additionally, the unbonding period for SHD is 21 days, similar to other blockchains in the Cosmos ecosystem.

2. Silk ($SILK) Token

Minting

There are two ways to mint Silk tokens:

(1) DAO entry, deposit $1 worth of sSCRT tokens to mint 1 SILK;

(2) Burning, burn $1 worth of Shade tokens to mint 1 SILK;

Pegging

The process of burning in sync with arbitrage helps maintain Silk's peg during rapid expansions and contractions in supply and demand.

Expansion: If Silk's price is above $1, to resolve the peg difference, the supply of Silk must be increased. Here, arbitrage will take the lead. Arbitrageurs will burn SHD tokens at a price of $1 to mint Silk, which will create selling pressure on Silk and re-peg its price to $1.

Contraction: If Silk's price is below $1, to resolve the peg difference, the supply of Silk must be decreased. This leads to the opposite behavior of arbitrage hunters compared to the expansion scenario, thereby re-pegging Silk's price to $1.

Sustainability:

Value enters the Silk and Shade ecosystem through two pathways:

1. Fiat > SCRT -> sSCRT -> Shade, or
2. Fiat > SCRT -> sSCRT -> Silk;

In the future, other assets (such as Secret tokens enabled by IBC) may also be used for burning.

Absorbing Volatility Shocks through a Global Currency Basket

Silk aims to address the volatility of single fiat stablecoins and sovereign currency risks. This is achieved by pegging Silk to a basket of global currencies used by the top 20 economies, with weights determined by relative GDP.

This creates lower volatility (compared to other fiat currencies and stablecoins), relative stability, bank independence, and immunity to the currency risk of any single sovereign currency.

Notably, Silk can add additional commodities and currencies to its peg through Shade Protocol governance, meaning Silk will not be permanently bound to a single configuration.

Of course, Silk will be subject to strict scrutiny and regulation (if it occurs). However, Silk has a unique positioning as it is neither a reserve currency nor directly pegged to a single sovereign currency.

This means that, unlike other algorithmic stablecoins, Silk can maintain its peg and be minted by other tokens, ultimately becoming a basket of currencies rather than just the governance token of the protocol.

Synthetic Asset Protocol

Shade also plans to launch a synthetic asset protocol, which, once completed, will become the first privacy-preserving synthetic asset protocol ever. What does this mean? It means that anyone with access to Shade can mint and trade other synthetic assets while protecting their privacy. To track the prices of real-world assets, Shade will use oracle services provided by Band Protocol.

Token Distribution

Now that we have understood the complex tokenomics of SHD and SILK, let’s take a look at the distribution of SHD tokens:

Why Stake My SHD Tokens?

To incentivize SHD token staking, the project employs a 10-year reward model, with 12.36% of the SHD supply allocated to reward stakers. Additionally, there are other non-inflationary reward sources for stakers, such as:

1. Treasury bonds;
2. Synthetic asset markets;
3. Treasury SCRT staking;
4. SHD <-> $SILK exchange fees;
5. SILK transaction fees;
6. Staking derivatives;
7. Others;

Furthermore, SHD staking collateral is deposited into an arbitrage contract to help maintain Silk's peg (similar to how LUNA plans to provide collateral for UST through various means, not just minting/burning mechanisms).

Private Placement Situation

Tokens from private placement institutions will be unlocked linearly over 24 months, with approximately 1061 SHD unlocking daily (25 different organizations and individuals, averaging 42.44 SHD unlocked per investor daily). Frankly, this private placement unlock schedule is quite reasonable, especially when compared to other projects (e.g., those in the Solana ecosystem).

Summary of Tokenomics

While the dual tokenomics of SHD/SILK looks great and the SHD token has real value, its FDV and token distribution situation are not ideal. A significant amount of assets is entrusted to the company/DAO itself. There is also an additional issue regarding private placements. However, in this era, this is almost always expected.

That said, we have seen that large development funds perform well in other projects. This is because it helps develop a vibrant and expansive project and user ecosystem.

Comparison with Terra (LUNA)

Whenever any protocol involves the interaction between stablecoins and their staking/governance tokens, thoughts immediately turn to the relationship between LUNA and TERRA (various stablecoins). In this section, we will compare the interactions of LUNA/TERRA and SHD/SILK. We will also explore hypothetical possibilities for the future development of SHD and SILK—using a dApp similar to Anchor.

The pegging and minting mechanisms of SHD/SILK are almost identical to those of LUNA/TERRA. Let’s take a look at Terra's pegging mechanism so we can see the similarities on paper.

One major current difference is that LUNA can also mint/peg various other fiat currencies, such as KRW, MNT, etc.

Another existing difference is the minting tax of LUNA. The protocol profits by issuing various currencies. For example, if the protocol mints 1 TERRA, there is no cost incurred. However, the protocol receives 1 LUNA in return, which is then burned. All minting taxes in the Terra protocol are destroyed, making Luna essentially deflationary. In Shade Protocol, SHD and SILK are exchanged.

The contraction and expansion mechanisms of LUNA work similarly to Shade, and likewise, LUNA is used as a governance token and for staking rewards for validators.

Thus, we can conclude that SHD and LUNA function as variable counterparts to their respective stable assets. By adjusting supply, the prices of LUNA and SHD will rise with market demand for stablecoins.

Anchor

Undoubtedly, one of the most attention-grabbing dApps built on the Terra blockchain is Anchor. Let’s see how Anchor works and how we hypothesize a similar dApp could exist on Shade.

In simple terms, Anchor is a fixed-income protocol that can provide a continuous stream of returns. How does it achieve this? Anchor provides a market for borrowing stablecoins, and by aggregating PoS block rewards and lending, Anchor can offer unleveraged, debt-free yields. This means that any depositor in the protocol can earn interest rates.

Let’s try to break down how these mechanisms actually work. First, we need to understand how loans operate. The loan-to-value ratio of any unstable, illiquid collateral is lower, so the borrowing capacity of these collaterals is limited. Conversely, for stable, liquid asset collateral, the situation is the opposite. This naturally means that Anchor is a multi-collateral system where borrowers can open various types of loans.

Then we have collateral derivatives, which in the case of Anchor are bAssets (bonded assets). The simplest way to explain bonded assets is to depict them as tokenized shares of PoS blockchains.

This means they are essentially liquid derivatives that allow token holders to earn staking rewards without waiting for a long unbonding period to end (which is often the case with Cosmos/Tendermint chains), freeing up a large amount of assets that can now be used as collateral to earn yields. These rewards are then returned to the depositors of the Anchor protocol.

Thus, the Anchor protocol aggregates PoS rewards, providing returns to users who store their assets. Therefore, this can be seen as an interest rate linked to the on-chain income generated by a basket of PoS blockchain assets.

All of these mechanisms can be applied on Shade, especially when considering that ShadeDAO plans to accumulate value from various applications on the protocol. These applications are expected to provide ShadeDAO with a healthy, growing balance sheet, some of whose profits can be used to support APYs similar to those of the Anchor protocol.

Of course, the main issue with Anchor is that their balance sheet continues to decline, forcing the LUNA Foundation to continually deposit large amounts of UST to support the APY. If Shade can develop enough value-accumulating applications, along with aggregating PoS rewards, then Shade will have the capability to build and maintain a better version of Anchor.

Token Release and Airdrop

Like most Cosmos-based protocols launched this year, the SHD token has adopted an airdrop distribution method and has been provided to contributors of the Cosmos and Secret ecosystems.

Of the 14.5% airdrop allocation, 20% was completed on February 21 to incentivize testnet contributors and participants who staked SCRT, ATOM, or LUNA between November 7, 2021, and December 13, 2021.

The remaining 80% of the airdrop will be claimable by users at the launch of the protocol.

This helps ensure a relatively fair release. You can check if your address has an airdrop here. Note that you need to claim the airdrop as soon as possible within one month after the protocol launch; otherwise, they will be reclaimed and redistributed to the community pool.

Roadmap

1. Q2 2022: Testnet | Audit | Mainnet Launch
2. Q3 2022: Synthetic Asset Protocol | Exchange Listings | Partnerships
3. Q4 2022: Shade Protocol Applications and More