[UNI-V2-DAI-USDT] 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: 4%
Liquidation Ratio: 125%
Debt Ceiling: 5 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: 2,000 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. There is an active signal request to increase the liquidation penalty and minimum bid increment parameters for Uniswap LP vault types, and any changes will be applied to this vault type as well.

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-USDT is the Uniswap LP token consisting of DAI and USDT. The pool currently has $16 million in total deposits and averages roughly $1 million per day in trading volume.

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-USDT 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-USDT 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 199 total holders of UNI-V2-DAI-USDT, with the top 10 holders comprising over 80% of total liquidity.

Source: Etherscan, Feb 2021

Token Deposits on Trading Venues and DeFi Exposure

UNI-V2-DAI-USDT 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-USDT is not currently integrated with any major defi platforms.

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

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

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

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

E.g. if USDT 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-USDT loss = -0.106

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

With a proposed liquidation ratio of 125%, USDT would need to fall roughly 36% before vault debt begins exceeding collateral value. This margin of safety exceeds the 33% loss capacity for the existing USDT-A vault type.

Historical Fee Returns

Uniswap liquidity pools earn a 0.3% fee from each trade. As both USDT and DAI track 1 USD, LPs in the UNI-V2-DAI-USDT pool bear low risk of divergence loss or other price risk. While fee returns have fluctuated widely, they have recently been trending downwards towards the 5-10% APY range. The chart below shows annualized fee returns based on trailing 7 day average trading volume and liquidity.

Source: Uniswap.info, Feb 2021

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

USDT is issued by Tether Ltd, a Hong Kong based company closely linked with the Bitfinex exchange. Tether primarily banks with Deltec, a financial institution based in the Bahamas. Despite being non-US based, the US still has legal leverage over USDT by controlling access to wire transfer infrastructure needed for fiat deposits and redemptions.

Tether gives very low transparency into reserves backing issued USDT. While it claims to be fully backed, it admitted in legal proceedings to being only 74% backed by cash equivalents at points in the past. It does not provide audited financial statements or detailed breakdowns of reserve composition, only giving a claim of total assets and liabilities and a letter from their attorney.

The USDT token contract gives Tether the ability to freeze or arbitrarily alter token balances. Tether has used these powers relatively frequently over the past year, with dozens of addresses frozen or seized. In a notable recent case, funds hacked from the Yearn yDAI vault were seized by Tether. The risk of seizure should be lower than the USDT-A vault due to the distributed nature of pool ownership among multiple parties.

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-USDT 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-USDT is exposed to any potential drop in the price of USDT, although it would face only slightly more than ½ as much loss as holding USDT directly.
  • Tether is not transparent about their reserves. If the reserves fall in value or are insufficient to cover redemption requests, the price of USDT could fall precipitously.
  • Tether could have its banking services restricted due to commercial or regulatory reasons. This could interfere with redemptions and cause price drops, even if Tether had funds available to meet the redemption requests.
  • If the UNI-V2-DAI-USDT pool were frozen by the Tether issuers, all funds locked in the pool (DAI and USDT) would be unrecoverable until the freeze is lifted. Tether’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-USDT.
  • 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: 4%
Liquidation Ratio: 125%
Debt Ceiling: 5 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: 2,000 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. There is an active signal request to increase the liquidation penalty and minimum bid increment parameters for Uniswap LP vault types, and any changes will be applied to this vault type as well.

Because the risk of UNI-V2-DAI-USDT is primarily from USDT 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 USDT-A vault type. The initial risk premium is set lower than the assumed 8% USDT-A risk premium due to lower exposure to potential USDT price declines, and less risk of MakerDAO being individually targeted for freezes or seizure.

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

Lead Researcher: @monet-supply

Sources:

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