[UNI-V2-DAI-USDC] 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

Risk Premium: 3%
Liquidation Ratio: 110%
Debt Ceiling: 10 million DAI
Dust: 2000 DAI

Note: Debt ceiling will initially be set at 3 million DAI, and can be increased after completion of audits on Uniswap collateral type oracles.

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-USDC is the Uniswap LP token consisting of DAI and USDC. The pool currently has over $20 million in total deposits, and is the 3rd most liquid DAI pool on Uniswap.

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-USDC 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-USDC 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.

Per etherscan data, there are 390 total holders of UNI-V2-DAI-USDC, with the top 12 holders comprising over 50% of total liquidity.


Source: Etherscan

Token Deposits on Trading Venues and DeFi Exposure

UNI-V2-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.

UNI-V2-DAI-USDC is not presently integrated with any defi platforms or lending services.

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

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

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

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

E.g. if USDC price suffers 20% percentage drop:

Loss from existing holdings = -0.2 * 0.5 = -0.1

Divergence loss = ((2 * sqrt(0.8) / 1.8) - 1) * (1 - 0.1) = -0.006

UNI-V2-DAI-USDC loss = -0.106

20% drop in USDC price leads to 10.6% drop in UNI-V2-DAI-USDC value, assuming no change in DAI price and excluding any positive fees earned by LPs. The relationship between USDC and UNI-V2-USDC price performance is shown below.

With a proposed liquidation ratio of 110%, USDC would need to fall roughly 18% before vault debt begins exceeding collateral value. This margin of safety exceeds the 1% loss capacity for the existing USDC-A vault type.

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.

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 5-15% APY. The chart below shows annualized fee returns based on trailing 7 day average trading volume and liquidity.


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.

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 freeze partial balances of addresses, 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 US based bank accounts and is audited periodically, and 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.

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-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.
  • UNI-V2-DAI-USDC is exposed to any potential drop in the price of USDC, although it would face only slightly more than ½ as much loss as holding USDC directly.
  • If the UNI-V2-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 0.05% platform level swap fee, which would be taken from LP earnings and could reduce demand to borrow against UNI-V2-DAI-USDC.
  • 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 (and by extension would reduce borrowing demand from Maker).

Proposed Risk Parameters

Risk Premium: 3%
Liquidation Ratio: 110%
Debt Ceiling: 10 million DAI
Dust: 2000 DAI

Note: Debt ceiling will initially be set at 3 million DAI, and can be increased after completion of audits on Uniswap LP collateral type oracles.

Because the risk of UNI-V2-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 stablecoin collateral types.

Risk parameters were selected to approximately match the existing, community approved USDC-A vault type. The initial risk premium is set lower than the assumed 4% USDC-A risk premium due to lower exposure to potential USDC price declines and less risk of MakerDAO being individually targeted for blacklisting. Similar to existing USDC vault types, liquidations will be disabled for UNI-V2-DAI-USDC, and the protocol will assume constant prices of $1 for both DAI and USDC. For this reason, auction parameters have been omitted.

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

Lead Researcher: @monet-supply

Sources:

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