[MATIC] Collateral Onboarding Risk Evaluation

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

Summary Proposed Risk Parameters

Stability Fee: 3%
Liquidation Ratio: 175%
Debt Ceiling: 10m
DC-IAM gap: 3m
DC-IAM ttl: 8h
Cut: 0.99
Step: 90 seconds
Buf: 1.30
Cusp: 0.4
Tail: 140 minutes
Chip: 0.1%
Tip: 300 DAI
Ilk.chop: 13%
Tolerance: 0.5
Ilk.hole: 3m DAI
Dust: 10.000 DAI

Overview

Protocol Summary

The Polygon Network (previously Matic Network), aims to become an Ethereum scaling aggregator that will offer a range of scaling technologies and services, including: PoS/Plasma chains, zkRollups, Optimistic Rollups, and Validium chains. Polygon will offer a generalised framework to allow the development of application-specific, Ethereum-compatible blockchains, that can use different scaling technologies, while still benefiting from interoperability. The first product from the Polygon Network to gain significant traction is the Polygon POS/Plasma hybrid chain, an EMV compatible scaling solution which provides both Proof-of-Stake (PoS) and Plasma-enabled sidechains. MATIC is the native token of the Polygon Network. It is currently being used to contribute to the security of the Polygon PoS chain through staking, to pay for gas fees, or to participate in the Polygon Network governance.

Matic Network was first founded in October 2017 by Jaynti Kanani, Sandeep Nailwal, and Anurag Arjun. In February 2021, the project was rebranded to Polygon Network. The rebrand also meant an expansion in mission and technology scope, focusing on becoming “Ethereum’s Internet of Blockchains”. The expansion would include: (i) more focus on other major scaling solutions, such as zkRollups, Optimistic Rollups, and Validium, (ii) inter-chain communication protocols, (iii) new data availability solutions, and more. The focus shifted to developing an ecosystem akin to Polkadot, Cosmos, and Avalanche while benefiting from Ethereum’s existing security, network effects, openness, and flexibility.

The Polygon PoS chain currently has 100 validators. Validators and delegates stake MATIC by depositing the tokens into a staking contract deployed on Ethereum L1. In exchange, they earn rewards in MATIC. The Polygon PoS chain is referred to as a “commit-chain”. This means that the chain periodically commits/checkpoints to Ethereum in order to achieve Ethereum based finality. This means that (i) the Polygon network relies on Ethereum security, and (ii) Polygon pays gas fees on Ethereum L1 to secure the staking contract and achieve checkpointing.

To deposit funds from Ethereum to Polygon, users need to go through a bridge. Polygon currently offers two bridges that allow users to deposit funds into Polygon: the Plasma bridge, and the PoS bridge. In practice, when depositing funds to Polygon, users lock funds into a contract on Ethereum L1. The corresponding amount of tokens are then minted on Polygon as a pegged token (1:1). To withdraw funds, users need to go back through the bridge. This means that the funds on Polygon are burned, and the funds in the Ethereum L1 contract are unlocked, and can then be withdrawn. The withdrawal process currently takes between 1-3 hours on the PoS bridge, and 7 days on the Plasma bridge. The Plasma bridge inherits the security of Ethereum, while the PoS bridge is secured by the Polygon PoS chain validator set.

It is worth noting that both the PoS/Plasma and Custom “Child ERC20’’ contracts are currently upgradeable by multisigs that can be activated by 5/8 signers. The signers are the Polygon co-founders, and four other individuals with protected identities from projects: Curve Finance, Quickswap, Cometh, and Horizon Games. However, the Polygon team has stated that once the contracts have been battle-tested, they will explore moving from multisigs to governance-controlled proxies, introduce timelocks, and eventually completely remove multisigs.

On-chain fundamentals

Addresses holding MATIC

Since the announcement of the Polygon rebrand on February 9, 2021, Polygon Network and the MATIC token have seen rapid growth and adoption. For instance, the amount of unique addresses on Ethereum holding MATIC tokens has increased by approximately 453%, from circa 24,084 to 109,133 at the time of writing.

Unique addresses holding MATIC

Source: Nansen

Daily active addresses

Starting in April 2021, the growth of daily active addresses rapidly accelerated. This coincided with the launch of Polygon’s joint liquidity mining programmes with DeFi protocols Aave (April, 13) and Sushiswap (May, 6). The number of active addresses on the Polygon PoS chain is now approximately 139,000, a 120x increase from February 2021. At the time of writing, daily active addresses on Ethereum are circa 502,000, according to Etherscan. Polygon currently has 27.6% of Ethereum’s daily active addresses.

Source: Polygonscan

Transactions on Polygon PoS chain

Low transaction fees, compared to Ethereum L1, is a key benefit of the Polygon PoS chain. Transaction fees have remained relatively low, despite the large rise in users, with only a few sporadic surges in price. According to Polygon Gas Station, the average gas fee on June 16, 2021, was 0.00263 MATIC ($0.000929). Daily transactions have followed similar growth to daily active addresses, increasing by approximately 142x from February (64,457 transactions) to circa 9.17 million transactions by June 16 according to Polygonscan.

Total Value Locked (TVL)

The Polygon Network currently has over 350 dapps deployed across DeFi, NFT, Gaming, and the DAO space. This has contributed to rapid growth in TVL, which is approximately $11 billion at the time of writing, a 12.7x increase from March 2021, according to Defi Llama.

Metrics and Analysis

Trading volume on CEX & on-chain venues

Traditional CEX Trading Activity

MATIC is actively traded on several centralised exchanges, including Binance, OKEx, Coinbase, and Huobi. Binance has significantly higher MATIC volume, compared to the other CEXs. For example, on May 19, the day MATIC experienced the highest volume throughout all exchanges (a total of $6.34 billion), Binance accounted for $5.36 billion (circa 84.5% of all volume). The second-largest exchange by volume, Coinbase, accounted for $349.11 million (circa 5.5% of all volume). At the time of writing, the total volume was $1.5 billion, while Binance accounted for $1.22 billion (81.3% of all volume) and Coinbase $50 million, (3.3% of all volume).

Traditional CEX Trading Activity (per exchange)

Source: Block Analitica & CryptoCompare

Most of MATIC’s trading volume happens on BUSD, USDT, USD, and BTC trading pairs.

Traditional CEX Trading Activity (per asset pair)

Source: Block Analitica & CryptoCompare

On-chain Trading Venues

In general, trading volume on Uniswap is higher than on Sushiswap. For example, on May 19, 2021, both trading venues recorded all-time highs in trading volume. The volume on Uniswap reached $66 million, while Sushiswap reported circa $525,000. It is also worth noting that on-chain trading volume, compared to CEX trading volume, is relatively low.

On-chain Trading Venues Trading Activity

Source: Block Analitica

As illustrated in the chart below, liquidity is also greater on Uniswap compared to Sushiswap.

On-chain Trading Venues Asset Deposit - Liquidity

Source: Block Analitica

Token Distribution & Issuance Schedule

Token Distribution

The total token supply for MATIC is capped at 10 billion. The Foundation Contract, Vesting Contract, Marketing & Ecosystem fund, and Network Mining & Seeding fund account for circa 3.7 billion (37% of total supply) MATIC tokens. By excluding these tokens, the remaining circulating supply of MATIC equals approximately 6.3 billion. Additionally, approximately 1.6 billion MATIC is currently being staked to secure the Polygon PoS chain, according to Polygon Staking.

Source: MATIC Etherscan

Polygon has raised capital through a private sale, through a Binance Launchpad Sale (IEO), and from Coinbase Ventures. Other MATIC tokens have been distributed to other investors, the team, advisors, network operations, foundation, and ecosystem. The initial token distribution is shown in the table below:

Source: Messari

Issuance Schedule

The chart below shows the issuance schedule from April 2019, and for the next 4 years. It shows that by May 2025, almost all the supply of MATIC tokens will have been distributed. The emission schedule suggests that after October 2022, MATIC tokens will only be distributed through staking rewards. According to Matic documentation, 12% (1.2 billion MATIC) of the total supply cap will be distributed over time to fund staking. This is to ensure sufficient staking activity early on before transaction fees eventually gain traction.

Source: Messari

Liquidity mining

In addition, Polygon has recently initiated liquidity mining incentives to attract new users. They have created joint liquidity mining programmes with other DeFi protocols, such as Aave and Sushiswap. For example, on April 13, a joint liquidity mining initiative with Aave was announced. Throughout April 14 to June 14, 0.5% (50 million MATIC) of the total MATIC supply was allocated to Aave Polygon markets to incentivise liquidity. Another 0.5% of the total supply of MATIC will be distributed between June 17, 2021, to Jan 17, 2022. Similar liquidity mining programmes have been initiated with other DeFi projects, where either Polygon offers MATIC incentives, DeFi protocols offer their native token or both. Other protocols Polygon is working with to incentivise liquidity includes: Curve, Sushiswap, and Hop Protocol.

EIP-1559 on Polygon

To remain compliant with the Ethereum network and tooling, Polygon intends to adopt London hard fork changes and updates. This includes adopting EIP-1559, which will split the transaction fee into a basefee and a priority fee (or tip). On Ethereum, the basefee will be burned for every transaction. Polygon has a fixed supply cap of 10 billion MATIC, while the Ethereum network adopts a more nuanced monetary policy of minimum necessary issuance. This means that if Polygon decides to burn MATIC tokens, planned payouts, such as checkpoint rewards, will have to be restructured.

Prabal Banerjee, Researcher at Polygon, recently proposed that Polygon should not burn the basefee, but rather allocate the basefee to a new contract that eventually will be governed by a Polygon DAO. Once the contract and DAO are established, the community can decide if MATIC tokens should be burned. At the time of writing, this is still only a proposal. However, the London hard fork will likely have an effect on the monetary policy of MATIC tokens irrespective of community decisions.

Token Deposits on Trading Venues

The chart below shows the distribution of MATIC deposits across top trading venues. Coinbase holds 4.2% out of the total supply cap of MATIC. This is a significant and disproportionate amount compared with the other top trading venues. Most tokens are held on centralised exchanges. For example, Uniswap is the leader among on-chain trading venues but is only number 14 in the top trading venue list of MATIC deposits. This gives rise to two key concerns: (i) risk of concentrated supply on Coinbase, and (ii) low on-chain liquidity that may negatively impact MATIC token accessibility.

The amount of MATIC tokens held on the top 14 trading venues represents approximately 12.3% of the total circulating supply and circa 7.8% of the total supply cap of MATIC tokens.

Source: Nansen

Token deposits on Polygon PoS Chain

At the time of writing, approximately 658 million MATIC is locked in the Polygon Plasma Bridge contract. Quickswap, a DEX built on Polygon, has circa $86.5 million worth of Wrapped Matic (WMATIC) in liquidity. This equals approximately 72 million MATIC at current prices ($1.19). However, it is important to note that this liquidity is not equal to on-chain DEX liquidity on Ethereum L1. First, withdrawing tokens from Polygon applications to L1 may take several transactions, and second, the bridge withdrawal process takes longer than withdrawing tokens directly from DEXs running on L1.

Downside Risk

The MATIC token has experienced both larger, and more frequent drawdowns compared to ETH. The period covered in the chart below is from May 1, 2019 to June 22, 2021 on the daily, and May 30, 2019 to June 22, 2021 on the hourly. Note that MATIC has experienced both one -60% drawdown and one -70% drawdown, while ETH’s largest drawdown during the same period was -50%.

Source: Block Analitica & CryptoCompare

Daily volatility, calculated from hourly prices over a period of 90 days

The chart below represents 90 day hourly price changes for the MATIC token, from March 10, 2021, to June 22, 2021.

Source: Block Analitica & CryptoCompare

The chart below compares MATIC’s volatility with other existing collateral types. MATIC is the most volatile asset, while MANA is the second most volatile asset on the chart.

Source: Block Analitica & CryptoCompare

DeFi presence

By being one of the first production ready scaling solutions on Ethereum, Polygon has been able to attract many users and capture value. The Polygon PoS chain is fully EVM compatible. This means that redeploying protocols and applications from Ethereum L1 is very efficient. Currently, 350+ dapps have been deployed across DeFi, NFT, Gaming, and the DAO space. Completely new projects, forks of L1 projects, and existing projects on L1, such as Aave and Sushiswap, have been deployed on Polygon. The current TVL of Polygon is approximately $11 billion, according to DeFiLlama.

However, it is not clear if Polygon will be able to protect its first-mover advantage once other scaling teams ship their products. Competition in the space is high, and within the next 6 months, scaling solutions such as Arbitrum, Optimism, and zkSync will launch to the public. The arrival of new market participants might change the market share of the Ethereum scaling landscape. This change can only be quantified once relevant data is available.

The use of MATIC in DeFi on Ethereum L1 is currently limited. However, some protocols built on top of Polygon accept MATIC as collateral, such as Aave’s Polygon market. Furthermore, all applications making use of the Polygon need to pay transaction fees in MATIC. This means that the MATIC token is embedded in all DeFi activity built on top of the Polygon PoS chain.

Summary of Notable Risks

  • Centralisation risk: Currently, the PoS/Plasma and Custom “Child ERC20” contracts can be changed, and are controlled by a 5/8 signer multisig. The Polygon team has stated that they eventually will explore moving to governance-controlled proxies. However, no clear timeline has been given.
  • Token concentration risk: 37% of total MATIC supply cap (circa 3.7 billion MATIC) is currently being held by the foundation contract, vesting contract, marketing & ecosystem fund, and network mining & seeding fund.
  • Social consensus: According to Matic documentation, if there is a bug, hack, or exploit in the system, the most likely solution would be to restore the chain to an earlier state through social consensus. Trusting that social consensus will work well enough to mitigate these issues, without any real experience of the success of social consensus, is currently a non-quantifiable risk. In addition, restoring the chain to an earlier state will not help get stolen funds back if the bridge contracts that are deployed on Ethereum L1 are hacked or exploited.
  • Monetary policy: The monetary policy for MATIC will change during the upcoming London hard fork. The Polygon community has yet to decide if the basefee for Polygon transactions will be burned, or sent to a Polygon DAO treasury. The effect that these options may have on MATIC’s monetary policy is currently unclear.
  • Downside risk: MATIC has experienced a -60% and -70% drawdown. In addition, MATIC has experienced more frequent drawdowns in ranges between -10% and -50% compared to ETH. The -70% drawdown was one of the largest short-term drops in crypto history. Hence, larger than usual jump severity of 40% for similar assets has been simulated in the risk model (-45% for base case).
  • Volatility risk: The MATIC token has exhibited more volatility than any other collateral type currently used in Maker Vaults.
  • Concentration of trading activity: At the time of writing, 81.3% of all MATIC trading volume occurred on Binance, which may suggest a single point of failure risk. In contrast, it should be noted that Coinbase holds by far the largest proportion of MATIC tokens (circa 423 million MATIC).
  • Polygon PoS chain validators: The Polygon PoS validator set is currently 100. The Binance chain currently accounts for approximately 30% of all MATIC staked. The top six nodes on Polygon account for approximately 69.5% of all MATIC staked. This may represent a collusion risk. However, as long as 2/3 of the weighted stake of the validators is honest, the chain will progress accurately. If 2/3 of the weighted stake validators are not honest, a validator has the power to stop the progress of the chain, or reorder blocks. It should be noted that validators cannot change the state, or the user’s asset balances.
  • Competition risk: Scaling Ethereum is currently a very competitive space with many high quality teams working on several new technologies. Scaling solution providers such as Optimism, Arbitrum, zkSync, and others have yet to release their final solutions to market. Hence, it is still unclear how the scaling landscape will evolve and grow. It is possible that another scaling solution may emerge as a dominant player. If that is the case, Polygon risks losing market share and users.

Risk Premium Curve

Since the MATIC token has demonstrated considerably higher volatility compared to other collateral types, higher severity of jumps (-45% for base case) has been applied to the simulations. A liquidation ratio of 175% is proposed for the MATIC token. This is similar to other more volatile collateral types.

Source: Block Analitica

Proposed Risk Parameters

Stability Fee: 3%
Liquidation Ratio: 175%
Debt Ceiling: 10m
DC-IAM gap: 3m
DC-IAM ttl: 8h
Cut: 0.99
Step: 90 seconds
Buf: 1.30
Cusp: 0.4
Tail: 140 minutes
Chip: 0.1
Tip: 300 DAI
Ilk.chop: 13%
Tolerance: 0.5
Ilk.hole: 3m DAI
Dust: 10.000 DAI

A link to our model specification with inputs and outputs can be found here. Data for graphics included in this report can be found here and here.

Lead Researcher: @Sean

Sources:

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