Shade Protocol Investment Report | Deep Dive

Review Date: June 11, 2021

Shade Protocol is an array of connected privacy-preserving DeFi applications built on Secret Network.

Overview: What is Shade Protocol?

In the words of the Shade development team, “Shade Protocol is an array of connected privacy-preserving DeFi applications built on Secret Network.” They are attempting to create a suite of DeFi primitives that will all accrue value for the native governance and treasury token (SHD).

Shade aims to create a system where a user can interact with any DeFi application under one user interface. This will greatly simplify the user experience because all applications will be in the same place and will all function using the same token ($SHD). This system will also allow Shade to accrue value for stakers and the native treasury, as well as act as a single governance token for the entire protocol. This UX (all applications under one hood) could help facilitate a significant network effect.

Why Secret Network?

Most smart contract platforms, most blockchains in general really, are public by default. Every transaction and the entire history of transactions are publicly available for anyone to view. There are a number of advantages to the transparent model that most blockchains use, but there is a very real argument for why there needs to be an element of privacy in Web3.

Secret Network is a Layer-1 blockchain that focuses on privacy. Secret Network’s native coin ($SCRT) is public and allows for all transactions to be visible on the blockchain. But the privacy-preserving tokens of the network ($sSCRT) are encrypted and allow for confidential transactions between parties. The $sSCRT tokens require a viewing key that is controlled by the user (but can be shared) to view the data within the transaction. Secret Network’s goal is to bring privacy to all major blockchains through its programmable smart contracts (Secret Contracts) and become the go-to interoperable privacy hub.

Aside from the privacy aspect, Secret Network is built on the Cosmos-SDK framework and features the Tendermint consensus core. This framework allows it to communicate and interoperate with all other blockchains built using the Cosmos-SDK framework (i.e. Binance Chain (BNB), Terra (LUNA), and Crypto.com Coin (CRO)).

This layer of interoperability paired with privacy presents a new narrative for DeFi and blockchain-based applications. It may not be apparent yet, but the more that Web3 is integrated into our daily lives, the more a degree of privacy will matter in our transactions

Silk

Silk is the first DeFi primitive being built on Shade Protocol. It is a privacy-preserving and smart contract interoperable stablecoin. It is built using the SNIP-20 private and fungible token standard. SNIP-20 allows users to maintain transactional privacy from the public blockchain while the sender and receiver are able to view the transaction details through viewing keys.

Silk is an algorithmic stablecoin that maintains its peg to a basket of global currencies and commodities through Band Protocol oracles integrated into Shade Protocol. The weight of each currency in Silk will be based on that nation’s contribution to global GDP.

Because Silk is comprised of a basket of currencies and commodities, it is inherently resistant to any currency crisis that a single nation may experience. If the currency in question loses value relative to other currencies, its weight in the basket will drop in accordance with its value.

Silk is designed to maintain a peg of $1.05 but for simplification purposes, the explanation will display Silk as pegged to $1. If Silk is trading above its target peg (at $1.02), Shade holders have the opportunity to burn $1 worth of their Shade tokens in return for $1.02 of Silk. This creates an opportunity to profit through arbitrage as well as expanding the supply of Silk in order to drive the price back down to its target peg. If Silk is trading below its peg (at $0.98), Silk holders can burn 1 Silk (valued at $0.98) and exchange it for $1 worth of Shade. This creates another opportunity to profit from arbitrage by decreasing the supply of Silk to drive it back to its target peg.

Tokenomics

One of the reasons why the Token Metrics research team is so interested in Shade is due to their token economics model. Shade Protocol features a dual-token system: $SHD, the governance and treasury token, and $SILK, the algorithmic stablecoin. Shade ($SHD) has a total supply of 10,000,000 tokens that will be distributed over the next 10 years through various vesting schedules.

The dual-token model is almost identical to Terra’s (LUNA-UST) model with the added benefit of privacy. Terra has had enormous success with its LUNA-UST arbitrage model and burn mechanism. Shade is essentially taking that model, adding 2 (DAO/Treasury & staking collateral) additional stability mechanisms, and adding a layer of privacy.

Both Shade and Silk can be minted in two ways: DAO entry minting and conversion minting. Entry minting is a process where users can deposit funds (either SCRT, LUNA, or ATOM) directly into the Shade DAO and receive an equal value of SHD or Silk in return. Conversion minting is based on the burn mechanism where users are able to burn SHD in return for Silk or burn Silk in return for SHD.

Burn Mechanism

Shade Protocol’s burn mechanism is referred to as “conversion minting”. It is the process of a user converting their Shade into Silk or converting Silk into Shade. Shade Protocol uses the same model as Terra’s LUNA-UST, but with the added benefit of privacy.

This burn mechanism is one of the ways that Shade Protocol will algorithmically stabilize their Silk stablecoin. When the price of Silk deviates too far in value from its target peg, Silk will either be burned or minted in order to drive the price back to its target peg.

Shade DAO

The Shade DAO, known as Synthesis, is a decentralized balance sheet of crypto-assets that is managed by Shade governance. It allows users to use the entry minting function and send sSCRT in exchange for Shade or Silk.

Synthesis uses the funds that are deposited in the form of sSCRT and stakes them to earn rewards and secure the underlying blockchain. These staking rewards are distributed to Shade stakers and back to the treasury.

Synthesis is also one of the arbitrage players that participate in the peg maintenance of Silk.

Synthetic Assets

One of the DeFi primitives that the Shade team has mentioned is synthetic assets. These synthetic assets will be in the form of tokens on the blockchain that will mirror the price and volatility of a specific off-chain asset.

The synthetic asset model will be broken down into 2 pieces: the synthetic asset token and a stabilizer token (that will be unique to each synthetic asset). It is important to note that each synthetic asset will have its own unique stabilizer token because this model aims to separate the risks and volatility of each synthetic asset. If there was only one stabilizer token for multiple synthetic assets, there would be a risk that if one synthetic asset price dumps, the algorithm would drain the market cap of the stabilizer token to maintain the stability of the synthetic. With unique stabilizer tokens, if one synthetic falls, it will not drag down the whole system with it.

It will follow the same burn mechanism as SHD-Silk, but instead of being pegged to a stable price, the synthetic tokens will be following the target price of a moving off-chain asset. Shade is currently using Band Protocol for oracles but has partnered with SupraOracles to foster interoperability, fast finality, increased scalability, secure computations, and truly decentralized oracles.

For the time being, the synthetic assets will focus on commodities and indices due to regulatory issues surrounding synthetic stocks.

Shade Value Accrual

Shade Protocol’s tokenomics model is attractive because its governance and treasury token ($SHD) is deflationary, accrues revenue and value for stakers from multiple DeFi primitives, and will be interoperable with other IBC-enabled blockchains.

$SHD, the governance and treasury token of Shade Protocol, will accrue value in multiple ways, namely: Silk transaction fees, conversion minting fees, staking rewards (12.36% of the token supply is allocated to staking rewards), Shade treasury, lending/borrowing products (interest accrued from lending and borrowing will go to Shade stakers), DEX transaction fees, synthetics conversion, and minting fees, and staking derivatives are all planned to launch on the protocol.

The more DeFi primitives that are launched through Shade Protocol, the more the $SHD token will accrue value through fees and rewards for stakers.

Token Allocation

Of the total supply, 12.36% has been set aside for staking rewards. The Shade development team has made a point that these staking rewards are not considered a part of the Shade token value accrual. These rewards are specifically to incentivize stakers to secure the protocol.

Staking Shade ($SHD) will also allow users to participate in governance and value accrual through a number of DeFi primitives.

In addition to staking rewards, 15% of the supply has been set aside for liquidity-providing incentives. Liquidity is imperative to make it convenient for users to obtain Shade and Silk. Protocol-owned liquidity mitigates the need to incentivize the liquidity itself.

14.5% of the total token supply has been distributed to LUNA, ATOM, and SCRT stakers via airdrop. The first airdrop (20% of the total airdrop) has just taken place on February 21, 2022. The rest of the airdrop (80%) will be taking place with the launch of the mainnet and Silk.

Unfortunately, only users who were staking their LUNA, ATOM, or SCRT from November 7 – December 13, 2021, were eligible for this airdrop.

10% of the token supply has been set aside for a Community Pool. This is the Shade DAO / treasury. These tokens will function as a means to maintain price stability for Silk and make governance requests/propositions for the protocol.

12.34% of the supply has been dedicated to grants. These grants will be used to develop DeFi primitives on Shade, Silk adoption, and community growth. The team has stated that these tokens may be used as rewards for Hackathons, milestone-based projects, and community initiatives. The team is encouraging developers to approach them with proposals for the grants.

23.25% of the token supply is being allocated to a development fund. This fund will be used for the development of DeFi primitives as well as to secure as many integrations as possible. The Shade team is working diligently to onboard as many developers as possible to expedite the process of building and maintaining the protocol.

1.5% of the supply has been allocated to launch expenses. This includes marketing expenses, influencers, branding, community contributors, and part-time builders who helped to promote or build Shade Protocol.

7.75% of the total token supply was allocated to a private funding round. The private sale tokens follow a vesting schedule over the next 2 years. Shade Protocol received $12.5 million in funding from private investors ($7.5 million over target). The additional investments were rejected by the core team. The private investors were essentially selected based on their alignment with Shade and what they could bring to the community.

The final 3.3% of the supply has been allocated to advisors and listing costs for centralized exchanges. Shade Protocol currently has 4 advisors. These advisors will receive tokens through a 4-6 year vesting schedule as well as a 6-month initial cliff.

You can read more about the specifics of the token allocation here.

Development Team

The founder of Shade Protocol is Carter Woetzel. He is a graduate of Bethel University with a BS in Computer Science and Finance. He has extensive experience with Secret Network as a co-founder of Secure Secrets, which is a Secret Network blockchain validator and software development company, as well as being the author of the Secret Network Graypaper. Carter is also a published blockchain author. His book, “Building Confidence in Blockchain” was published in August 2020.

The core developer at Shade Protocol is Guy Garcia. He is a graduate of the University of Puerto Rico-Mayaguez with a BS in Computer Engineering. Prior to working on Shade, he worked as a software developer intern at ABB, a global technology company, as well as a software engineer intern at CapitalOne. He has an active GitHub account illustrating a technical background with experience programming in Rust, C++, and Python.

Shade Protocol recently scored a 76% in a technology and code review from Token Metrics in late January 2022.

Investors / Partnerships

Shade recently closed a $5 million private round, raising capital from 20 investors. The most notable investor and partner is Secret Labs, founders of Secret Network and actively mentoring the Shade Protocol team. The team stated that they received a total of $12.5 million in private funding ($7.5 million over their goal). This overfunding allowed for the core team to be selective in their private token allocation and only allocate tokens to private investors who were aligned with the ethos of Shade Protocol could help advance the community and be a value-add partner.

This capital will be used to continue developing the protocol and to support core developers and contributors who are working to bring privacy-preserving DeFi to Secret Network.

Valuation

Shade Protocol currently sits at a fully diluted valuation (FDV) of approximately $490 million. This is roughly 50% of the valuation of its native blockchain, Secret Network ($936 million), and approximately 0.9% of the FDV of Terra ($55 billion). This means that for Shade Protocol to reach an equal FDV of Terra, it would need to increase its valuation by roughly 100x+. This presents immense ROI potential and room for growth in the future. But it is important to note, that Shade’s valuation may be limited in the near term because of throughput issues with Secret Network and also due to token unlocks of investors.

Risks

One of our major concerns with Shade Protocol is the low throughput and limited transactional capabilities of Secret Network. Secret Network is currently operating at 25 TPS with 6-second transaction finality. This throughput is comparable to Ethereum (roughly 20 TPS). This is minute in comparison to LUNA (advertised as 10,000 TPS with 2-second transaction finality). Users who were eligible for the airdrop ran into various issues when attempting to claim their airdrop rewards because Secret Network was congested and nodes began to fail. Secret Network runs on hardware-based solutions, namely Intel SGX. There will be a significant upgrade coming to this hardware in 2024 but until then, Secret Network users will have to endure the current throughput. This hardware upgrade is roughly 2 years away. This presents a risk of another project solving the same issues as Shade but on a more efficient chain (possibly an entire new blockchain-focused on privacy).

Shade Protocol relies heavily on oracle price feeds for Silk and synthetic asset pricing. The accuracy of the Silk stablecoin will be based on how accurately the oracles can rebalance the weights of each currency based on GDP. What happens if these oracles are inefficient?

The Shade Treasury / DAO (Synthesis) aims to hold multiple blockchain assets (SCRT, ATOM, LUNA, BTC, etc.). There is still a question of how they will be able to execute this idea of diversifying their treasury collateral.

Secret Network’s throughput issues present the risk that Shade may not be able to grow and scale to the level that it strives for in the short term. Secret Network is only able to process 22-23 transactions per block. A DeFi protocol with ambitions like Shade will require much greater throughput if it is to scale to the level that aims to. One interesting optionality could be later down the road they fork an L1 to scale.

There may be limited upside potential in the short-term future in terms of valuation for Shade because its FDV is already more than 50% of the underlying blockchain that it was built on top of. But again, we have seen this play out with MOVR which has a similar valuation as KSM, the native blockchain it was built on.

Shade’s goal is to create a suite of DeFi applications that all accrue value back to one token. This is a revolutionary idea in DeFi but has not yet been proven to be efficient. There is still a question of how the respective dApps would compete against each other and how they would balance token incentives.

Shade Protocol is an ambitious project and they are still in the very early stages of development. There is a token available ($SHD) on SecretSwap and SiennaSwap, but the mainnet is not yet complete and neither is the Silk stablecoin. There is still an element of execution risk that investors must be aware of.

Investment Thesis

Shade Protocol is a project that aims to be a pioneer in privacy-preserving DeFi. It is a very ambitious project and many aspects of the project are experimental, but the risk-reward is asymmetric and presents a rare opportunity with 100x ROI potential in the long term.

The tokenomics of Shade Protocol are something that we have not seen up until now. It is an extension of Terra’s LUNA-UST model with an added layer of privacy and two additional stabilizer mechanisms. Adding a layer of privacy to a unique, algorithmic stablecoin is a revolutionary model that is only the beginning of its kind. The unique algorithmic stablecoin coupled with the multiple streams of revenue (DeFi applications, Shade DAO) and value accruals for one governance token (SHD) is what makes Shade Protocol such an exciting project.

The way we see it, Shade Protocol has the potential to revolutionize DeFi for both institutions and retail investors, but this will take time. We are also living through very uncertain economic times which may turn into a global economic recession. The probability of a recession rises to 60%. whenever oil prices move above $100. At Token Metrics, despite liking the project we would only accumulate SHD after observing more execution and cheaper valuation. We believe the current valuation is mostly due to small float and illiquidity.

Overall, Shade Protocol brings revolutionary DeFi concepts into play. Combining that with impressive tokenomics, a solid development team, and a governance token that aims to capitalize on value accrual from a suite of DeFi applications and create real streams of revenue for token holders, there is an opportunity for a 100x ROI crypto project. But users must view this project through a long-term lens due to unstable financial markets and geopolitical conditions creating economic uncertainty throughout the world. We believe it would be best to sit on your hands for the time being and wait for a cheaper valuation and for the team to execute on their ideas (NFA).