My first impressions of THORchain and the RUNE crypto token were that those names sounded kind of gimmicky.
Without knowing anything about RUNE crypto, I assumed that it was just another meme coin that was going to do an impressive take-off only to crash back down into oblivion very soon after.
Granted, first impressions are often wrong as were mine.
It turns out the odd-sounding vocabulary used for this blockchain is just a result of quirky branding inspired by Norse mythology.
But don’t judge a coin by its name.
I am not here to “shill” you the RUNE crypto token in any manner but, after studying this project in a lot more depth, THORchain has earned a spot on the front shelf of my mental library for altcoins.
If you want to claim you understand the altcoin space well, then you need to know about THORchain
What is THORChain
To explain THORChain first I’ll abstract away all the complexity and oversimplify.
Then I will correct myself and put things in the right place.
ok, ready?
What is THORChain in simple language?
THORCHain is like Uniswap but cross-chain.
By cross-chain I mean you can trade any asset from any blockchain with another asset from another blockchain.
For example, Uniswap only allows you to exchange ETH and ERC-20 tokens.
If you want to exchange BTC for ETH you can’t.
With THORChain you can.
“Liar!” you shout. “I have swapped BTC for ETH many times on Uniswap”
Not exactly.
Uniswap only allows you to exchange “wrapped BTC”.
What is wrapped BTC?
A wrapped Bitcoin is an ERC-20 token that is backed 1:1 with Bitcoin by a third-party custodian.
To all intents and purposes, it is equivalent to bitcoin but it is not bitcoin.
Why should I care?
It depends on your perspective.
It may make no difference to you whether a bitcoin is wrapped or not.
But for the true crypto-anarchists who kicked off the whole crypto movement, it matters a lot.
To these cypherpunks, decentralized exchanges (DEXs) like Uniswap on Ethereum and DEXs on other ecosystems such as Solana, Binance Smart Chain, Avalanche, etc. are walled gardens.
They can only operate within the token standard of their blockchain.
THORChain allows you to transact in actual BTC without any third parties involved.
It is this immutability that is so distinguishing.
There is also the practical consideration that wrapped stuff gets hacked.
For example, the wormhole hack led to $320Mn worth of wrapped ETH getting stolen.
However, there is a further backstory to this.
Being able to move BTC about in this immutable manner in a decentralized ecosystem implies that you can avoid KYC.
This again matches the ethos and spirit of hardcore Bitcoin believers who believe that no central intermediary, such as governments, should have a say in how money moves about.
A more accurate description of THORChain
THORChain is a layer 1 blockchain that is built on the Cosmos SDK. If you don’t know what that is, check out my description here: What is Cosmos Crypto?
THORChain itself does not have a user-facing product.
It offers its technology as a platform for others to use.
One of the oldest and largest exchanges that now use THORChain to power their exchange is ShapeShift.
There are multiple teams building apps and interfaces where users can trade using THORChain.
The most famous of these is THORSwap.
How do THORChain and Rune crypto work
I am going to assume you understand how decentralized exchanges work in general.
If you don’t feel confident you understand liquidity pools, LPs, constant function formulas, impermanent loss, and so on then I would suggest you pause here and read my article on Uniswap first.
Knowledge in crypto is layered so you need to take things step by step amigo.
If you feel you have Uniswap and DEXs wrapped around your fingers then you are ready to peel the next layer of the onion.
How Rune crypto is used to swap assets
Let’s see what happens when you want to trade BTC for ETH on THORChain.
In a normal DEX, there would be a liquidity pool of BTC and ETH.
Think of this like a market stall with BTC and ETH sitting on it.
You drop your BTC on the countertop and pick up an equal value in ETH (minus a fee that goes to the people that have placed their wares upon the stall).
The problem is that a normal DEX would not be able to support such a liquidity pool because BTC and ETH live on different blockchains.
It’s just not possible!
So how does THORChain get around this conundrum?
Eh?
It’s simple really. THORChain makes liquidity pools using its native token RUNE.
So instead of a liquidity pool having 50% of the value in token A and 50% of the value in token B, it has 50% of the value in token A and 50% of the value in RUNE.
There is a separate liquidity pool against RUNE for token B.
As a trader, you can still exchange BTC for ETH but what is happening on the backend is that your BTC gets swapped for RUNE, and then that RUNE gets swapped for ETH.
I know your mind is buzzing now.
You are probably asking: “Ok, I get that the RUNE crypto token is the native token for THORChain but BTC and ETH aren’t so how does THORChain interact with them?”
Remember, all we are talking about here is ledgers.
So when you think ledger you should be thinking private keys and wallets.
Assets change hands by updating the status of the ledger.
So yes BTC cannot be on the THORChain blockchain.
What happens is that the BTC lives in a vault owned by THORChain.
Ermmm…What is a vault?
A vault in the crypto world is simply a wallet address from which withdrawals can happen only when certain conditions are met.
So when we say that liquidity providers provide BTC to THORChain we just mean that they are sending their BTC to a vault that lives on the Bitcoin blockchain and belongs to THORChain.
When I want to swap BTC for ETH then my BTC is sent to the Bitcoin vault.
Once this is confirmed an equivalent amount of ETH is released from THORChain’s ETH vault to my ETH address.
Who is checking and confirming the transfers?
Apart from traders and liquidity providers, there is a third group of stakeholders who are involved in the swap.
These so-called Node Operators are what set THORChain apart from other DEXs.
Let’s explore what Node Operators do
Each node operator operates…well.. nodes.
A node is just another confusing name for a computer.
Remember, anyone who wants to validate transactions on Bitcoin has to operate a Bitcoin node.
Similarly, for Ethereum, you need to operate an Ethereum node, and so on for Avalanche, Solana, etc.
So for each blockchain you want to verify and confirm transactions you need to operate a node.
And obviously, this being THORChain the Node Operators need a node for THORChain as well.
In keeping with their branding, Node Operators call the collection of nodes they operate a THORNode.
THORChain used to have 35 node operators but has now expanded to 126. In the graph below you see that 93 are active.
Now pay attention because I am going to introduce to you another innovation that the THORChain people are very proud of.
How transactions work on THORChain
For the transaction to occur, the Node Operators need to collectively agree that the Bitcoin has come into the vault.
This is easy to do. They just need to use their Bitcoin node and check if the transaction went through.
Once they see the bitcoin transaction they send this information to THORChain.
This is called a witness transaction and it just tells THORChain “Hello compadre, I have seen a bitcoin come into the vault”.
Effectively THORChain is a blockchain that is recording what is happening to the wallets it owns on different chains.
THORChain acknowledges the observation but keeps the status of the transaction as “Pending” until at least 2/3 of Node Operators report that they see the transaction.
Once a super-majority of nodes agree, THORChain updates the status of the transaction as “Finalised”.
So just to recap:
- The user transfers their Bitcoin to an address (vault) that THORChain owns.
- The node operators observe and report that this is so.
- And THORChain updates itself saying “ok everyone we have a new bitcoin in our vault”
Now it’s time for THORChain to give the user their ETH.
In order for this to happen, THORChain issues an instruction to the Node Operators who now have to sign the transaction for ETH to be released from THORChain’s ETH Vault and send it to the trader’s ETH address.
For the transactions to go through 2/3 of operators need to sign.
This is known as a Threshold Signature Scheme and THORChain’s creators are very proud of it as it allows them to securely authorize transactions on a majority agreement across blockchains.
How does THORChain ensure security?
Since we are talking about blockchains we need to understand what prevents Node Operators from colluding and reporting transactions in their favor.
There are two methods that enhance security.
1. Validators rotate in and out at random
To become a validator that signs transactions you need to bid more than others.
If you bid higher than others then you can become a node validator for up to a month and get rewarded accordingly before you are kicked out of the set.
Nodes churn in and out every 2 days. This makes it harder for anyone to game the system.
Note that verification of data is open to all. It’s only the signing that is restricted.
2. Game theory using RUNE crypto tokenomics
This is where the RUNE crypto token comes in.
With a fixed supply of 500Mn RUNE, the economic incentive structure put in place ensures that Node Operators are always truthful.
Let’s understand how this works in more detail.
Since THORChain uses Cosmos, it is a Proof-of-Stake blockchain.
For Node Operators to participate in the validation process and claim rewards they need to stake twice the value of the native assets in RUNE.
So for example, if there is $100Mn worth of BTC, ETH, etc in the liquidity pools then Node Operators need to collectively stake $200Mn worth of RUNE.
Note that unlike other Proof-of-Stake blockchains, you cannot delegate your RUNE crypto tokens to validators to stake.
Node Operators need to put up the funds themselves.
Bonding vs Staking
The word that THORChain uses for stake is “bond” and it means the same thing: you lock up your stake or post bond as collateral and if anything goes wrong then THORChain can claim that collateral to punish bad behavior.
Why use RUNE and not some other asset?
Because RUNE will drop to ~0 if there is a Sybil attack.
Let’s explore this in more detail:
Say I have evil intentions and want to take over the network.
All I need is a 2/3 majority. In my previous example, there is
- $100Mn worth of BTC, ETH, etc
- $100Mn worth of RUNE in the liquidity pools
- $200Mn worth of RUNE bonded by Node Operators
So say I get my hands on $134Mn in RUNE.
I now have my 2/3 majority to send all assets my way. What goodies do I get?
- $100Mn worth of BTC, ETH, etc
- $100Mn worth of RUNE in the liquidity pools. But the price of RUNE will drop to 0 because who is going to buy RUNE after a hack like this?
- $200Mn worth of RUNE bonded by Node Operators. Again goes to 0.
So I have ended up spending $134Mn to get $100Mn. No one should be willing to do this.
Of course, we will find out how this plays out in the future. For example, what if you have a short position on RUNE beforehand?
In any case, you can see why it makes sense to use RUNE, whose price will drop to 0, and not some other asset like BTC whose price will be less affected by what is going on THORChain.
Incentive pendulum
The 2:1 ratio for bonding is ensured through a mechanism called the incentive pendulum.
A high ratio means that resources are being wasted.
And when it is lower, security is at risk.
If you run the numbers you will see that as you slide below 67% it may become profitable for Node Operators to collude and steal assets.
In our previous example, we have
- $100Mn worth of BTC, ETH, etc (Dark blue area on the right)
- $100Mn worth of RUNE in the liquidity pools (sea green area with 33% of RUNE)
- $200Mn worth of RUNE bonded by Node Operators (sea green area with 67% of RUNE)
When the bonded RUNE exceeds 67% then THORChain starts to favor liquidity providers and rewards them more.
This causes funds to shift from bonding to liquidity provision.
The opposite occurs when bonded RUNE is below 67%.
What else do you use RUNE crypto for?
Apart from serving as collateral for Node Operators the RUNE crypto coin is
- A governance token. Not in the traditional sense of voting on proposals though. More in the sense that it signals priority for what assets to list next or what chains to use.
- Used by liquidity providers
- Used to pay fees to liquidity providers and rewards to Node Operators.
Why do liquidity providers need to post 50% of the value in RUNE crypto?
THORChain has copied Bancor’s model to create liquidity pools. The main reason behind this is that it is more efficient and offers deeper liquidity.
Let’s take a look at an example
THORChain liquidity pool example
Say you want to offer traders 4 assets to trade between. On a traditional DEX like Uniswap, you would need 6 liquidity pools. On THORChain you only need 4.
Extrapolate to N assets and you get N pools for THORChain but N! / 2*(N-2)! for Uniswap.
For example, for 100 assets THORChain needs 100 liquidity pools but Uniswap needs 4950.
As you can see the liquidity pools on THORChain are designed to be way deeper.
This should result in lower slippage fees.
Impermanent loss protection
THORChain follows Bancor’s model to offer some protection against impermanent loss.
Once you add assets to the liquidity pool THORChain starts counting days up to 100.
For each day it provides you with 1% impermanent loss protection.
THORChain starts counting from your last transfer.
So if you added funds last week but add more funds today it will reset the clock to 0 and start counting from today.
Impermanent loss protection example
Assume you provide your BTC to THORChain.
THORChain takes 50% and sells it for RUNE and places 50% BTC and 50% RUNE in its liquidity pool.
Let’s say 100 days have passed and you exit your position.
And let’s say that after you collect your fees from THORChain you would have been better off by simply hodling Bitcoin.
THORChain will pay you the difference. When I say it will pay you the difference I mean that it will pay you the difference between hodling 50% BTC and 50% RUNE vs providing it as liquidity. There is a difference between hodling 100% BTC and hodling 50% RUNE and 50% BTC. If you have 20mins to spare you can go through some examples of asymmetrical LP provision on THORChain.
Who started THORChain
The team behind THORChain is mostly anonymous. They claim to have no founders or CEOs etc.
The person who often appears on podcasts is their technical lead, Chad Barraford.
With an engineering and military background Chad became attracted to the values of blockchain in 2017.
At the time he involved himself in a hackathon and then slowly pivoted to what is now THORChain.
He says he gravitated towards Norse cosmology because he thought it would make good branding.
There were 9 people who formed the founding team of THORChain.
Over time the teams working on various aspects of the ecosystem have expanded.
There are currently 12 teams building various supporting apps from treasury fund block explorers to a variety of analytics tools.
In Chad’s view, this reflects the truly decentralized nature of THORChain.
Wrapping up THORChain
THORChain is a very powerful blockchain that facilitates cross-chain liquidity pools without wrapped tokens.
It wants to be a platform for exchanges to be able to trade BTC and other assets in an immutable manner.
THORChain already supports 7 chains including Bitcoin, Ethereum, Binance Chain, Dogecoin, Litecoin, and Bitcoin Cash. Its ecosystem of supporting apps and tools is growing fast.
I hope this short explainer on THORChain enlightened you. If you were please share far and wide. Thanks for reading!
If you wondering what to read next why not check my explanation for Olympus DAO and its wild APYs?
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