[UNI-V2-DAI-ETH] Collateral Onboarding Risk Evaluation

Legal Disclaimer : This communication is provided for information purposes only. The views expressed here are those of the individual quoted or who present said materials and are not the views of Maker Foundation (“Maker”) or its affiliates. This communication has been prepared based upon information, including market prices, data and other information, from sources believed to be reliable, but Maker has not independently verified such information and makes no representations about the enduring accuracy of the information or its appropriateness for a given situation. This content is provided for informational purposes only, and should not be relied upon as legal, business, investment, or tax advice. You should consult your own advisers as to those matters. References to any digital assets and the use of finance-related terminology are for illustrative purposes only , and do not constitute any recommendation for any action or an offer to provide investment advisory services. This content is not directed at nor intended for use by the MakerDAO community (“MakerDAO”), and may not under any circumstances be relied upon when making a decision to purchase any other digital asset referenced herein. The digital assets referenced herein currently face an uncertain regulatory landscape in not only the United States but also in many foreign jurisdictions, including but not limited to the UK, European Union, Singapore, Korea, Japan and China. The legal and regulatory risks inherent in referenced digital assets are not the subject of this content . For guidance regarding the possibility of said risks, one should consult with his or her own appropriate legal and/or regulatory counsel. Charts and graphs provided within are for informational purposes solely and should not be relied upon when making any decision. The content speaks only as of the date indicated. Any projections, estimates, forecasts, targets, prospects, and/or opinions expressed in these materials are subject to change without notice and may differ or be contrary to opinions expressed by others.

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

Summary Proposed Risk Parameters

Risk Premium: 1%
Liquidation Ratio: 125%
Debt Ceiling: 10 million DAI
Auction Lot Size: 50,000 DAI
Minimum Bid Increment: 3%
Bid Duration: 6 hours
Max Auction Duration: 6 hours
Liquidation Penalty: 13%
Dust: 500 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.

To incentivize users to provide liquidity, 0.3% of each trade is retained by the pool as a fee, increasing the underlying token balances of all participating LPs. However, being an LP is not without risk, as the pool will programmatically buy assets as the price falls or sell as the price appreciates. This leads to a phenomena known as “divergence loss”, where larger price moves cause LP tokens to underperform versus a benchmark of simply holding 50% of each asset.

Uniswap v2 pool contracts are mostly permissionless and non-upgradable. However, UNI governance has the ability to activate a 0.05% protocol level swap fee (reducing swap fees received by LPs from 0.3% to 0.25%) after a 180 day timelock, which could make participating as a Uniswap LP less economical. Uniswap’s contracts have been audited and are among the most battle tested of any application, but it is possible that an undiscovered flaw could lead to loss of funds.

UNI-V2-DAI-ETH is the Uniswap LP token consisting of DAI and ETH. It is currently Uniswap’s 4th most liquid pool with around $150 million in deposits, and also the most important venue for trading in the ETHDAI pair.

Metrics and Analysis

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

Uniswap LP tokens can be minted and redeemed from the pool contract with the underlying assets. There is essentially no trading of the UNI-V2-DAI-ETH tokens themselves, 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

UNI-V2-DAI-ETH tokens are created and redeemed via the Uniswap pool contract, so the total supply of LP tokens depends on users’ decisions to enter or exit the liquidity pool. There are no centralized minting functions or other inflationary factors in token supply.

Token Deposits on Trading Venues and DeFi Exposure

UNI-V2-DAI-ETH 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.

Per Etherscan data, the vast majority of LP tokens (~97%) were deposited in Uniswap’s incentivized UNI farming pool, with some deposited through yield farming protocols such as Yearn, Pickle Finance, and Farm. However, the Uniswap incentive program ended on November 17 and there was substantial outflow from the staking contract into individual wallets. The top 10 addresses in the UNI farming contract held approximately ~47% of the total supply of UNI-V2-DAI-ETH as of November 10, but this number was likely skewed by yield aggregators increasing ownership concentration. Currently, the top 10 holders (including the contract for the now ended UNI distribution) own ~82% of supply, and top 100 holders own ~95% of supply.

Source: Nansen, Nov 2020

There is a Uniswap market available on Aave that offers ETH or stablecoin loans against LP tokens from Uniswap v1 (note that the LP tokens for v1 are separate assets from v2). However, there is currently around $17,000 of UNI-V1-DAI-ETH deposited as collateral, demonstrating a low level of market utilization. Usage may be limited by the low amount of stablecoins and ETH available to borrow, as well as the fact that most liquidity has moved from Uniswap v1 to v2.

AlphaHomura is a yield farming platform which allows users to lever up in LP token positions to earn higher returns by borrowing ETH. As of 10 Nov 2020, the farm based on UNI-V2-DAI-ETH had ~$1.6 million in TVL, with around $800,000 in borrowing demand.

Downside Risk

Because Uniswap LP tokens are not traded independently, it’s not possible to check previous trading history to assess downside risks. But, Uniswap’s invariant function allows for calculating drawdowns deterministically based upon the price performance of constituent assets. Details about LP returns can be found in Uniswap’s blog and this Medium post.

Assuming the price of DAI stays stable, a decline in the price of ETH will lead to a corresponding decline in the price of UNI-V2-DAI-ETH from two factors: the loss in value of the 50% of the pool already held in ETH, and additional losses caused by “divergence loss”.

UNI-V2-DAI-ETH percentage loss = loss from existing holdings + divergence loss

Loss from existing holdings = ETH percentage price change * ETH allocation (50%)

Divergence loss = ((2 * sqrt(1 + ETH percentage price change) / (2 + ETH percentage price change)) - 1) * (1 + (0.5 * ETH percentage price change))

E.g. if ETH price suffers 50% percentage drop:

Loss from existing holdings = -0.5 * 0.5 = -0.25

Divergence loss = ((2 * sqrt(0.5) / 1.5) - 1) * (1 - 0.25) = -0.043

UNI-V2-DAI-ETH loss = -0.293

50% drop in ETH price leads to 29.3% drop in UNI-V2-DAI-ETH value, assuming no change in DAI price and excluding any positive fees earned by LPs. The relationship between ETH and UNI-V2-DAI-ETH price performance is shown below.

Uniswap v2 has only been live since May, but based on the past 5 years of ETH price history and Uniswap’s invariant formula, UNI-V2-DAI-ETH would have experienced substantially fewer sharp drawdowns in price than ETH. The largest price drawdown would have been 33%, experienced on 12 March 2020 on the same day when ETH price fell 55%.

Source: Coinmarketcap, Nov 2020

Historical Fee Returns

Uniswap liquidity pools earn a 0.3% fee from each trade. Over time, this income accrues to liquidity providers and helps counteract negative effects of divergence loss.

While annualized fee earnings frequently exceeded 200% at some points over the summer, they have dropped substantially in the past few months due to the massive inflow of liquidity. In particular, the UNI distribution incentivized deposits to UNI-V2-DAI-ETH despite relatively low fee returns. With incentives now ended, natural swap fee earnings have begun to increase as excess liquidity leaves the pool.

Source: Uniswap.info, Nov 2020

If Uniswap governance chooses to activate the protocol fee switch, 0.05% of each swap would be redirected from LPs to the Uniswap treasury. This would leave the remaining 0.25% swap fee for LPs, reducing their annualized fee earnings by around 17% assuming volume and liquidity remain constant.

Summary of Notable Risks

  • Technical risk: While Uniswap v2 is a well vetted system, there is a potential for undiscovered bugs or flaws to cause loss of funds.

  • Collateral that includes DAI such as UNI-V2-DAI-ETH 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.

  • UNI-V2-DAI-ETH will suffer from divergence loss when ETH experiences large moves. LP borrowers may have an incentive to repay their debt and remove liquidity during a large price decline, which would cause pro-cyclical pressures on MakerDAO if DAI supply and ETH liquidity contract during a downturn.

  • Uniswap governance can turn on a 0.05% platform level swap fee, which would be taken from LP earnings and could reduce demand to borrow against UNI-V2-DAI-ETH.

  • The Uniswap protocol liquidity mining program was only scheduled for a 2 month initial period. Uniswap governance may not renew the liquidity incentives, or may redirect them to other pools. This could reduce the total supply of UNI-V2-DAI-ETH and could have unpredictable impacts on borrowing demand.

  • Other decentralized exchange venues such as Sushiswap, Mooniswap, Bancor v2.1 or other platforms compete with Uniswap for volume. If Uniswap captures less volume, this reduces fee returns earned by LPs.

Proposed Risk Parameters

Risk Premium: 1%
Liquidation Ratio: 125%
Debt Ceiling: 10 million DAI
Auction Lot Size: 50,000 DAI
Minimum Bid Increment: 3%
Bid Duration: 6 hours
Max Auction Duration: 6 hours
Liquidation Penalty: 13%
Dust: 500 DAI

We used the model from the Collateral Risk Assessment Guide here. Inputs to the model are derived from trading data along with stressed input parameters. A link to our model specification with inputs and outputs can be found here. Auction parameters have been selected to mirror those for ETH.

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

Lead Researcher: @monet-supply

Sources:

16 Likes

Great work Monet!

Just wondering, what is the sentiment and consensus around backing Dai with Dai in this manner? I know it will also be backed by Eth but with a 125% ratio it still Dai that will make up a large portion of the backing.

1 Like

Backed dai with dai is for me, the 0 risk.
I don’t think there is any risk there by definition.
Am I right?

My understanding is it probably wouldn’t cause issues. In emergency shutdown, users would receive some LP tokens when they redeem their DAI, so they would likely need to go through a few cycles of redemption and unwrapping LP tokens to retrieve all of their funds. Smaller holders would probably just sell their DAI and larger whales and market makers could take care of the redemption process at scale.

Eg. a hypothetical emergency shutdown where there’s 80 DAI from ETH and 20 DAI from UNI-V2-DAI-ETH. There would be ~90 DAI in circulation (10 is locked in LP token collateral).

  1. Redeem 90 DAI, receive $72 worth of ETH and $18 worth of UNI-V2-DAI-ETH
  2. Unwrap UNI-V2-DAI-ETH, receive $9 worth of ETH and 9 DAI
  3. Current holdings $81 worth of ETH and 9 DAI
  4. Redeem 9 DAI, receive $7.20 worth of ETH and $1.80 of UNI-V2-DAI-ETH
  5. Continue…

Edge cases: if other parts of the collateral portfolio experience losses and DAI begins trading for less than $1 due to loss of confidence, this would impact the value of UNI-V2-DAI-ETH LP tokens and could lead to further defaults. However, in the past we’ve typically seen DAI price increase when other assets are under stress, so this situation seems unlikely.

5 Likes

This collateral adoption would be nothing but good for MKR and the Ethereum ecosystem in general. I imagine if the DAO allowed it, these liquidity pools (LP) could become huge, funded by less risk tolerant people of which there are a lot more of, rather than these wackos who want to trade ETH on margin, or even hodl ETH on margin.

The MKR loans based off of regular ETH vaults increase the volatility of ETH. This new type of collateral will make the ETH/DAI LP bigger; it should stabilize ETH.

It should create a lot more DAI, draw in more conservative investors seeking passive income while still wanting to participate in a possible ETH moonshot.

To be clear, what I am talking about is

Granny gives you $100 for your birthday.

  1. Buy $100 of ETH.
  2. Borrow $100 of DAI from someplace. (maybe a flash loan, maybe your credit card)
  3. Buy $200 ETH/DAI LP token using your ETH and borrowed DAI
  4. Borrow $100 DAI from MKR using LP tokens as collateral
  5. Pay back loan of step 2)
  6. Profit (more probable than not)
1 Like

UNI-V2-DAI-ETH has great synergies for the Maker Ecosystem.

5 Likes

This is particularly good as 50% of the holding is already in DAI. So at the liquidation threshold there would be $50 of ETH, $50 of DAI and $80 of borrowed DAI.

So essentially it’s $50 of ETH and a $30 of borrowed DAI (as the LP token can be redeemed for 50 DAI) This equates to a collateralization level of 166.6…% making it one of the safest vaults.

1 Like

Good work, thanks @monet-supply. Just wanted to note that Rates Group might potentially propose higher SF than your proposed Risk Premium of 1%. The low risk premium does make sense for a starting DC of only 10m, where model predicts at least 100m as Maximum DC. Both underlying assets are highly liquid. Also, I think @NikKunkel might propose even lower starting DC than 10m due to initial Oracles testing for UNI-LPs.

1 Like

How much do you mean by a higher SF? Are you considering a higher SF than ETH-A?

Also the Rates Group could potentially consider UNI-V2-DAI-ETH to have a lower SF than UNI-V2-USDC-ETH.

Well we usually look at competitive rates and if there is no one offering such collateral we can propose to set SF above risk premium, in this case much easier because RP is very very low. But it is definitely not up to me, it is to be discussed within the group and on forums.

Also it really depends on usage as well. If Uniswap restarts liquidity mining, we may not see much demand until such vault type has farming feature enabled.

Agree, DAI-ETH could carry a bit lower risk premium than USDC-ETH but I think it is almost negligible difference considering improved USDC-DAI liquidity overall and when implementing PSM. Also, DAI is 40% backed by USDC and possibly well over 50% after PSM.

I think it is not only about risk it is also about dai “used”.
Dai-eth use less dai than usdc-eth, because you stake some dai too.

I agree that currently it is not an issue but in theory, usdc pairs are twice as much costly for maker than dai pairs.

I really think that dai pair for multiple reasons should be cheaper than usdc pair. Hoping for much cheaper.

1 Like