There are very few ways to hedge against rapid price drops in ETH without going outside the blockchain (and even then, probably not many). This instrument would provide users a native crypto instrument that is negatively correlated with the price of ETH.
ETA: As has been pointed out, this structure could also work with X being a strike above the current price level.
ETA-2 This has been revised to provide significant revenues for MakerDAO.
Users deposit into a risk pool, which pays out should the price of ETH drop below strike price X.
I propose that MakerDAO provide smart contracts to administer a way to pool risk. Users would deposit capital in the form of DAI (denoted as K) into the pool. At any time, they may withdraw their proportional share of the risk pool according to the formula of K * r. The variable r is the rate set by the pool’s contract that is <1. This would allow unrestricted retrieval of capital up to r at any time for any reason. As an example, if a user had deposited 1000 DAI and r was .9 then they could on demand withdraw 900 DAI.
Should the price of ETH drop to or below X, then users may withdraw 100% of their proportional share of the risk pool.
After an early withdrawal from the risk pool, a user’s remainder capital (1- K * r) is forfeited to the pool. This raises the payout both at the strike price and for early withdrawal for all remaining users. A portion of the forfeited capital would become equity for MakerDAO within the pool. Example: A user who deposited 100 DAI into the risk pool withdraws, taking 90 DAI with them and leaving 10 DAI in the pool – 9 DAI distributed proportionately to other participants and 1 DAI distributed to Maker’s share within the pool. If Maker had not had a share yet, it would then receive it. I envision Maker partaking in both the proportionate gains and this fee.
Expected Behavior Of Instrument
As the price of ETH rises, fewer users will be incentivized to seek protection from ETH falling to any given strike X and may even result in a net exit of users who decide to use their capital elsewhere. While the intrinsic value of a position in the risk pool becomes less valuable due to distance from X it increases over time as other users exit the pool. The longer the pool is in existence, the more valuable a position in it will become, making it a tool for speculation activity as well as those actually seeking protection against drop below a certain strike.
As the price of ETH falls, more users will be incentivized to seek protection by entering the pool. If strike X is met, then this slowly dilutes older risk pool participants while keeping their returns positive relative to initial investment. It also in some circumstances may allow users to exit early with K * r that is > than initial K, thereby receiving both a profit and increasing the available K within the pool to remaining users.
This would be structured as a semi-perpetual risk pool. It would hold no expiration, meaning its value would be quite high for sideways or slightly down markets over long periods of time, as the underlying share of each user rises with each exit. Even for the first user to exit, (1- K * r) can be thought of as the premium paid for the protection enjoyed for the length of time participating in the pool. So there is value even to the first user to exit the pool.
The pool would wind down in one of two ways: The first is if the strike price X is met according to our oracle OSM feed. The pool would allow all participants to withdraw a share proportional to their initial contribution (adjusted for users that exited and forfeited a portion of their capital)
The second way would be if the pool’s participation dropped below a certain number. If all users exited the pool – perhaps X is now astronomically below the current price of ETH – then there would be a remainder of funds, and could be rolled into the Surplus Buffer. In order to speed up the wind-down of obviously low-value, illiquid pools, it may be worth preventing exits from accruing to remaining users at a certain threshold – 20% of maximum number of participants, for example.
ETA: The pool could also have an expiration on a predetermined time and day, similar to options contracts. Any funds remaining could revert to the DAO. I fear there’s some way to game this I haven’t thought of, but would give us recurring revenue instead of irregular windfalls.
Why Maker Should Do This
There is definitely room to structure fees in this product. But I don’t think Maker needs to. Because all DAI originates with our protocol, denominating these pools in DAI will both increase the number of use cases within finance for DAI and make any DAI in the pool somewhat locked in place – meaning that most of those DAI are probably minted in a way that generates fees for us every moment they exist.
This gives us both a comparative cost advantage over, say, Uniswap, and also moves us into a use case for DAI that USDC and Tether simply cannot do unless someone else mimics the market.
There should be network effects to this becoming a deep, liquid market. Because strikes are at static, nominal points, as demand dictates and prices move, new pools can be created at higher/lower strikes.
Should we choose to do so, this is also a tool that we could use to hedge our exposure to ETH – which is considerable right now. The DAO as an institutional actor would also be well-positioned to wait out participants that prefer to actively put their funds to work and churn into and out of any given pool. But the contract should be structured such that the DAO receives any remainder funds in risk pools that become defunct without being exercised.
ETA-2 After input form others and further thought, I think this can generate significant revenues for MakerDAO. As outlined in the Summary section above, the DAO would gain some small amount of proportional share of each pool through exits. This could either be kept until a risk pool winds down from lack of participation, or even withdrawn from the pool (leaving behind 10% or whatever r we choose) at any time.
Risks To The DAO
The main ones I see are reputational and opportunity cost. The DAO would not need to underwrite the pools itself, though it may wish to participate. The main cost I see is the diversion of resources in both technical and marketing implementation vs our core lending business. Perhaps we could even contract out parts of the work, though that’s beyond my expertise to comment on.
How To Do This
I am not knowledgeable about smart contract technical details. But this seems like it would be a fairly simple structure and easily repeatable. It would require minimal tie-in to anything other than our oracle feed and depositing excess funds from defunct pools into the SB.
The initial challenge would be getting the word out, but I suspect an initial pool would be easy to populate with participants already familiar with DeFi and looking for yield and hedges. From there, if the initial pool(s) prove popular, new strikes can be added and perhaps even other assets. Note that it would require only a price feed and not that the actual asset be on-chain with Ethereum.
Please leave your thoughts both technical and financial below.