[UNI-V2-ETH-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: 140%
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.

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-USDT-ETH is the Uniswap LP token consisting of USDT and ETH. It is currently one of Uniswap’s most liquid pairs, with over $200 million in deposits.

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-USDT-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-USDT-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.

There are currently 3000 total holders of UNI-V2-USDT-ETH. Nearly half of total liquidity remains deposited in the UNI farming contract, even though liquidity rewards ended in mid November. Excluding this rewards contract, the remaining 9 holders in the top 10 own ~33% of liquidity.


Source: Etherscan, Jan 2021

Token Deposits on Trading Venues and DeFi Exposure

UNI-V2-USDT-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.

UNI-V2-USDT-ETH is not presently integrated with any defi platforms or lending services. Alpha Homora offers a user interface that supports adding liquidity in unequal amounts, but so far they have not integrated the UNI-V2-USDT-ETH LP into their lending platform.

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 USDT stays stable, a decline in the price of ETH will lead to a corresponding decline in the price of UNI-V2-USDT-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-USDT-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% 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-USDT-ETH loss = -0.293

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

Uniswap v2 has only been live since May, but based on the past 5 years of ETH and USD price history and Uniswap’s invariant formula, UNI-V2-USDT-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, Jan 2021

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-USDT-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, Jan 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.

Credit and Custody Risk

Tether, the issuer of USDT, is under legal investigation and has a poor reputation for transparency. The underlying fiat holdings supposedly backing issued USDT have never been subject to audit or attestations from reputable law or accounting firms. If USDT has a deficit of reserves, USDT price could decline substantially and Tether may be unable to process redemption requests. Lack of controls and transparency around USDT minting versus fiat USD holdings also present risk of token minting attacks, where an attacker or insider mints unlimited tokens and then immediately uses them to drain liquidity from exchanges.

In the past, Tether has had banking relationships cut off, which resulted in long periods where redemption for USD was impossible. This creates risk of USDT trading below 1 USD, as users are not able to arbitrage the price difference. While Tether has had a relatively stable banking relationship for the past 2 years with Deltec, government actions could potentially inhibit Tether’s ability to process redemptions, even in cases where they have sufficient USD reserves. The chart below shows sharp price falls and increased volatility in 2017 and 2018 when Tether was unable to process redemptions.


Source: Coinmarketcap, Jan 2021

Tether also has the ability to freeze funds and arbitrarily change balances. If Tether froze USDT balances in the UNI-V2-USDT-ETH pool, all balances (USDT and ETH) would be unrecoverable until the freeze was lifted. This could substantially impair the value of the LP token, as they could no longer be redeemed for underlying assets. Because assets of multiple users are pooled within the Uniswap contract, it would not be possible for Tether to specifically target MakerDAO for censorship action, which reduces potential regulatory risk versus holding USDT as collateral directly.

The chart below shows USDT blacklisting activity through October 2020. Additional addresses have been restricted since then


Source: The Block, October 2020

Based on the high centralization risks of holding assets linked to USDT, this analysis proposes conservative risk premium and liquidation ratio parameters exceeding those set for UNI-V2-DAI-ETH or UNI-V2-USDC-ETH. While UNI-V2-USDT-ETH has lower exposure to USDT price declines (versus holding USDT directly), a total collapse of USDT would still lead to large losses. UNI-V2-USDT-ETH also faces additional risk from decline in ETH price that is not present for USDT-A vault.

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.
  • 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.
  • 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-USDT-ETH.
  • UNI-V2-USDT-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 both DAI supply and ETH liquidity contract during a downturn.
  • Tether has poor transparency over operational processes and reserves, and has never proven its solvency with a full audit. If USDT is insufficiently backed, it’s value could experience sharp and sudden drops when this becomes widely known. UNI-V2-USDT-ETH would face only slightly more than ½ as much loss as directly holding USDT, but a USDT collapse may also cause ETH price to fall simultaneously.
  • Tether could lose access to banking services, which would make it impossible to create or redeem USDT for fiat (even if Tether had sufficient USD reserves). USDT could experience much greater price volatility if users are unable to keep the price in line through creation and redemption.
  • Tether insiders or successful attackers on Tether could mint large amounts of unbacked tokens, causing losses to USDT holders and draining liquidity from liquidity pools such as UNI-V2-USDT-ETH.
  • Tether could freeze or burn USDT balances due to regulatory or legal pressure (or potentially other reasons per management discretion). If Tether froze the UNI-V2-USDT-ETH pool, all funds including ETH would be unrecoverable until the freeze is lifted.

Proposed Risk Parameters

Risk Premium: 4%
Liquidation Ratio: 140%
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.

We used the model from the Collateral Risk Assessment Guide here. We have adapted the risk parameters to take account of unique risks of USDT. 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:

Copyright and related rights waived via CC0.

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