[UNI-V2-LINK-ETH] 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: 165%
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: 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-LINK-ETH is the Uniswap LP token consisting of LINK and ETH. It is currently Uniswap’s 2nd most liquid pool with over $180 million in deposits, and also a top trading venue for the LINK-ETH pair. While it often boasts the highest volume for LINK among decentralized exchanges, Sushiswap’s LINK-ETH pairing has roughly twice as much liquidity deposited due to ongoing liquidity incentives.

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-LINK-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-LINK-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-LINK-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-LINK-ETH is not widely integrated with defi platforms or lending services. Alpha Homora offers a user interface that supports adding liquidity in unequal amounts, and offers up to 2x leverage on UNI-V2-LINK-ETH LP in their lending platform (only ETH borrowing is supported, not USD).

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.

A decline in the price of ETH or LINK will lead to a corresponding decline in the price of UNI-V2-LINK-ETH from two factors: the loss in value of the 50% of the pool already held in the declining asset, and additional negative returns caused by “divergence loss”.

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

Loss from existing holdings = LINKETH percentage price change * ETH allocation (50%) + LINKUSD percentage price change * LINK allocation (50%)

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

E.g. if LINK price suffers 50% price drop while ETH suffers 30% drop:

Loss from existing holdings = (-0.5 * 0.5) + (-0.3 * 0.5) = -0.4

Divergence loss = ((2 * sqrt(0.7142) / 1.7142) - 1) * (1 + (0.5 * -0.2858)) = -0.012

UNI-V2-LINK-ETH loss = -0.412

50% drop in LINK price and 30% drop in ETH price leads to 41.2% drop in UNI-V2-LINK-ETH value, excluding any positive fees earned by LPs. The relationship between LINK or ETH price changes and UNI-V2-LINK-ETH price performance is shown below.

Uniswap v2 has only been live since May, but based on the past 1.5 years of ETH and LINK price history (based on Coinbase data) and Uniswap’s invariant formula, UNI-V2-LINK-ETH would have experienced significantly fewer sharp drawdowns than LINK. The largest price drawdown (measured from close to close) would have been 53%, experienced on 12 March 2020 on the same day when ETH price fell 55%.

Source: Cryptocompare, Jan 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 to the pool. In particular, the previous UNI distribution incentivized deposits to UNI-V2-LINK-ETH despite relatively low fee returns. However, with the UNI incentives now ended, swap fee returns have been on an uptrend as excess liquidity exits 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

  • While Uniswap v2 is a well vetted system, there is a potential for undiscovered bugs or flaws to cause loss of funds.
  • A large portion of the LINK supply is still under the effective control of the core team. If this supply were released rapidly or unexpectedly, it could cause a severe price drop.
  • UNI-V2-LINK-ETH will suffer from divergence loss when ETH or LINK experience 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 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-LINK-ETH.
  • 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.
  • LP tokens including ETH increase MakerDAO’s already substantial exposure to ETH price movements.

Proposed Risk Parameters

Risk Premium: 4%
Liquidation Ratio: 165%
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: 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. 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:

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