[G-UNI DAI-USDC] Collateral Onboarding Risk Evaluation

Legal Disclaimer: This evaluation is provided for information purposes only, and does not constitute financial, investment, legal, regulatory, or tax advice. The author(s) and MakerDAO Risk Core Unit cannot guarantee the accuracy of data and information contained in the report, which is provided strictly on a best efforts basis. References to assets are made for informational purposes, and are not a recommendation, offer to sell, or solicitation of an offer to buy any asset. Content, data, or assessments provided in this evaluation are subject to change without notice. This report may include certain forward looking statements; such statements face a high degree of uncertainty and are not a guarantee or promise of future performance or events. Author(s) and the MakerDAO Risk Core Unit are materially relying on waiver of liability as a condition of providing this report. By accessing the content below, readers agree to indemnify and hold harmless author(s) and the MakerDAO Risk Core Unit against any and all claims.

  1. Summary Proposed Risk Parameters
  2. Overview
  3. Metrics and Analysis
  4. Risk Parameters

Summary Proposed Risk Parameters

Risk Premium: 1%
Liquidation Ratio: 105%
Debt Ceiling: 10 million DAI
DC-IAM gap: 10 million DAI
DC-IAM ttl: 8 hours
Cut: 0.999
Step: 120 seconds
Buf: 1.05
Cusp: 0.9
Tail: 220 minutes
Chip: 0.10%
Tip: 300 DAI
Ilk.chop: 13%
Tolerance: 0.95
Ilk.hole: 5 million DAI
Dust: 10,000 DAI

Overview

Protocol Summary

Uniswap is a decentralized protocol that allows for permissionless asset exchange and passive market making. Uniswap uses an invariant function (x * y = k) to quote prices of asset pairs based upon the relative quantity of those assets in a liquidity pool. If the price differs from the prevailing market price, arbitrageurs are incentivized to trade against the pool to correct the price discrepancy. Any user can join a liquidity pool by depositing equal valued amounts of each asset.

Uniswap v3 brings some marked changes to the system’s design. It offers several fee tiers ranging from 0.05% to 1% per swap, with smaller fees being optimized for stable value assets to encourage greater trading volume. It also allows users to provide liquidity within a concentrated price range, which improves capital efficiency (particularly for stablecoin pairs where liquidity can be concentrated close to 1:1 ratio). This gives users a greater share of fees and improves liquidity for traders, but also increases risk of divergence / impermanent loss. Uniswap governance has control over fees in v3, and can take up to 25% of LP fee earnings to the protocol in the future. Currently protocol fees are turned off and all swap fees go to LPs.

Unlike in Uniswap v2, LP shares are created as non fungible tokens (NFTs) and do not automatically reinvest fee earnings. G-UNI-DAI-USDC is a fungible strategy token that represents deposits into the Uniswap v3 DAI-USDC 0.05% fee pool between the 0.9994 and 1.0014 DAI/USDC price ranges. Fee earnings are reinvested into the pool via the Gelato network, a system of keepers that provides automation services while limiting risk of frontrunning and other abuses. 1% of reinvested earnings are withheld by Gelato as a protocol fee.

Metrics and Analysis

Trading volume on CEX & non-custodial venues (excluding Uniswap)

G-UNI LP tokens can be minted and redeemed from the pool contract with the underlying assets. G-UNI is not traded directly on any markets, so liquidity of LP tokens is best understood as a function of the liquidity of constituent assets. As an example, keepers can liquidate LP token positions by redeeming the token with the contract and then selling the underlying assets.

Token Distribution & Issuance Schedule

G-UNI supply increases and decreases to correspond to user deposits and redemption. There are no inflationary supply factors, and total supply is based purely on user deposits.

Token Deposits on Trading Venues and DeFi Exposure

G-UNI-DAI-USDC is not listed for trading on any centralized or decentralized exchange venues, as creation and redemption is available directly through the pool contract with no fees or slippage. G-UNI-DAI-USDC is not presently integrated with any defi platforms or lending services.

Downside Risk

Because G-UNI LP tokens are not traded independently, it’s not possible to check previous trading history to assess downside risks. Instead, we’ll look at the constituent assets and price curve to determine downside risks.

G-UNI-DAI-USDC is made up of USDC and DAI. Unlike in Uniswap v2, where liquidity is provided across the entire range of possible prices, this G-UNI strategy concentrates liquidity between 0.9994 and 1.0014 DAI/USDC price. If USDC falls to a price of 0.9986 or below the LP pool will be held 100% in USDC. This means G-UNI-DAI-USDC experiences essentially all of the downside price risk of USDC.

Historically USDC has traded with very low volatility, which means historical downside volatility is a poor measure of risk in this case. Reasons USDC could decline in value include insolvency of the issuer Centre, default on their reserve investments, interruption of creation/redemption for fiat, or seizure of the reserves through legal or regulatory action – all of these represent more of tail risks rather than ordinary market risk.

G-UNI-DAI-USDC price change = min(USDC percent change, DAI percent change)

E.g. if USDC price suffers a 20% percentage drop in value, the G-UNI strategy suffers a roughly equivalent loss.

With a proposed liquidation ratio of 105%, this allows for a roughly 5% drawdown in the price of USDC before Maker begins to experience losses on the exposure. This is a significantly larger buffer versus existing USDC based vaults including the PSM and USDC-A, which both allow for 1% or less price drawdown in USDC.

Historical Fee Returns

Uniswap v3 allows liquidity providers to charge a fee of either 1%, 0.3%, or 0.05% per swap. The G-UNI-DAI-USDC pool features a 0.05% swap fee. While fees are not automatically reinvested in Uniswap v3, the Gelato Network uses a system of incentivized keepers to reinvest funds on behalf of LPs, in exchange for a 1% cut of fee earnings.

As both USDC and DAI track 1 USD, LPs in the UNI-V2-DAI-USDC pool bear low risk of divergence loss or other price risk. While fee returns have fluctuated widely, they have generally ranged between 2-10% APY.

The chart below shows annualized fee returns based on trailing 7 day average trading volume and liquidity, with a few caveats. 50% of the G-UNI-DAI-USDC LP is held in the 0.9994-1.0004 range, while the price has been within this range well under 50% of the time; this leads to an overstatement of returns as the G-UNI LP has less targeted liquidity than the pool overall (where roughly 70% of TLV is held in the 1.0004-1.0014 range). In a worst case scenario where all trading takes place within the 1.0004-1.0014 range, the G-UNI LP would earn roughly 70% of the rate of return listed in the chart below.

Source: Uniswap.info, July 2021

If Uniswap governance chooses to activate the protocol fee switch, between 10% to 25% of each swap (value decided by governance) would be redirected from LPs to the Uniswap. This would leave the remaining 0.0.0375% to 0.045% swap fee for G-UNI LPs, reducing annualized earnings by up to 25% versus the existing status.

Centralization and Custody Risks

USDC is issued by Centre, a consortium consisting of Coinbase and Circle that is subject to US and global financial regulations. Centre has the ability to freeze or blacklist addresses due to court orders or other legal requirements. If Centre froze balances in the UNI-V2-DAI-USDC pool, due to the way Uniswap is designed all funds (USDC and DAI) in the pool would be unrecoverable until the freeze had been lifted. This could substantially impair the value of UNI-V2-DAI-USDC, due to inability to redeem tokens for underlying assets.

On the other hand, Centre cannot differentiate between funds held in a single address, so the decision to freeze the Uniswap pool would impact all pool depositors. This results in somewhat lower risk of blacklisting or freezing versus USDC vaults or PSM, where censorship action could be directly targeted at MakerDAO.

USDC is held in investments approved by Circle, including US bank accounts, US government debt, and corporate debt, and is audited periodically. The risk of credit losses or default on USDC is considered low. However, USDC holders would be exposed to any potential losses in underlying fiat funds. Additionally, if redemption activity was curtailed due to operational or regulatory reasons, the price of USDC could trade below $1 even while remaining fully collateralized.

Gelato Network runs the automation bots that allow for reinvestment of fee earnings into the G-UNI LP. They have committed to removing key admin powers before integration with MakerDAO, so the risk of loss of principal from Gelato network custody practices should be eliminated. But it could be possible for bots participating in the network to front run or otherwise exploit the fee reinvestment transactions - this is considered unlikely as malicious action could be spotted and the offending party removed from the network with minimal profit opportunity. This issue would only affect recent fee earnings before reinvestment, so the impact to Maker and vault users would be low.

LP Behavior During Emergency Shutdown

The Maker protocol includes the ability to shut down the system during emergencies through a global settlement process. When this happens, each DAI becomes redeemable for $1 of underlying collateral. But as soon as shutdown is triggered, fluctuating prices of the basket of collateral assets will begin to push DAI’s redemption value above or below $1 (this price drift can happen even during the 6 hour shutdown period before DAI becomes redeemable for collateral). Concentrated DAI-stablecoin liquidity (including G-UNI-DAI-USDC) as collateral introduces asymmetric downside risk to DAI collateral value in these circumstances.

To give a concrete example, let’s imagine a hypothetical collateral portfolio of 100 DAI backed 50% by ETH and 50% by G-UNI-DAI-USDC. When global settlement is triggered, each DAI will be backed by $0.50 of ETH and $0.50 of G-UNI-DAI-USDC.

If the price of ETH falls 50%, initially each DAI would be backed by $0.75 of collateral ($0.25 of ETH and $0.50 of G-UNI-DAI-USDC). But because DAI would now be trading at a discount, all of the USDC liquidity in the G-UNI LP will be drained for DAI, leaving each DAI backed by $0.25 of ETH and 0.5 DAI - through redemption, this will yield $0.5 ETH for each circulating DAI token.

G-UNI-DAI-USDC experiences essentially all of the downside exposure of the rest of the DAI collateral portfolio. On the other hand, the upside of G-UNI collateral is capped at $1 because any rises in DAI price above that threshold would lead to all of the G-UNI LP being held in USDC.

Summary of Notable Risks

  • Technical risk: Uniswap v3 was released within the past few months, and has a relatively short history compared with other decentralized exchange platforms. The G-UNI implementation is also new and relatively untested. Undiscovered technical issues could potentially cause loss of funds.
  • Collateral that includes DAI such as G-UNI-DAI-USDC could increase potential losses for DAI holders if emergency shutdown occurred while there was bad debt (negative DAI surplus). If Maker took action that reduced the collateral backing of DAI below $1 (eg. negative interest rates), this may also lead to increased DAI holder losses in an emergency shutdown event.
  • Even in cases where there was no bad debt during an emergency shutdown, significant amounts of G-UNI-DAI-USDC collateral could lead to lower DAI redemption value depending on the performance of other volatile assets within the portfolio.
  • G-UNI-DAI-USDC is fully exposed to the downside risk of USDC, so a price discount caused by credit losses or lack of confidence could lead to under collateralized debt and losses to Maker.
  • If the UNI-V3-DAI-USDC pool were frozen by the USDC issuers, all funds locked in the pool (DAI and USDC) would be unrecoverable until the freeze is lifted. USDC’s freeze and burn functionality makes this asset vulnerable to censorship or legal/regulatory pressure.
  • Uniswap governance can turn on a platform level swap fee, which would be taken from LP earnings and could reduce demand to borrow against G-UNI-DAI-USDC.
  • Other decentralized exchange venues such as Curve and Sushiswap compete with Uniswap for volume. If Uniswap captures less volume, this reduces fee returns earned by LPs (and by extension would reduce borrowing demand from Maker). This could force Maker to charge lower stability fees.

Proposed Risk Parameters

Risk Premium: 1%
Liquidation Ratio: 105%
Debt Ceiling: 10 million DAI
DC-IAM gap: 10 million DAI
DC-IAM ttl: 8 hours
Cut: 0.999
Step: 120 seconds
Buf: 1.05
Cusp: 0.9
Tail: 220 minutes
Chip: 0.10%
Tip: 300 DAI
Ilk.chop: 13%
Tolerance: 0.95
Ilk.hole: 5 million DAI
Dust: 10,000 DAI

As with other stablecoin assets, liquidations will be deactivated for this collateral type. Because the risk of G-UNI-DAI-USDC is primarily from USDC tail risks (centralization, custody, and credit risk), it is not possible to generate appropriate risk parameters from previous price volatility and liquidity data. We have adapted the Collateral Risk Assessment Guide process to suit this stablecoin collateral type.

Risk parameters were selected based on expected risk of USDC exposure, with additional buffers to accommodate the relatively new implementation of G-UNI and Uniswap v3, along with the idiosyncratic price risks associated with concentrated v3 liquidity. Similar to existing USDC vault types, liquidations will be disabled for G-UNI-DAI-USDC, and the protocol will assume constant prices of $1 for both DAI and USDC.

Data for graphics included in this report can be found here.

Lead Researcher: @monet-supply

Sources:

11 Likes

As always, great research Monet. Totally appreciate your insights and research.

Question–the Smart Contract Audits for the Gelato Network–how do they stack? I clicked on the link you provided but I think its broken.

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Hey, the security of the G-UNI pools is actually enforced on the G-UNI smart contracts themselves. The only “malicious” act that Gelato Network (the network of keepers) can do it actually stop reinvesting fees on behalf of the G-UNI pool. This is however quite unlikely because this would also mean that Gelato will stop earning fees, so the incentives are quite well aligned to keep the fee reinvestments going while all of the security is enforced on the G-UNI contracts themselves.

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