[UNI-V2-USDC-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: 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


Protocol Summary

The Uniswap protocol 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 rebalance token weights and 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 directional 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 somewhat 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-USDC-ETH is Uniswap’s LP token consisting of USDC and ETH. Currently, it is Uniswap’s 3rd most liquid trading pair with over $150 million in total deposits, and a top decentralized venue for trading ETHUSDC based on 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-USDC-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-USDC-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-USDC-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 (~98%) 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 were substantial outflows from the staking contract into individual wallets. The top 10 addresses in the UNI farming contract held approximately ~86% of the total supply of UNI-V2-USDC-ETH as of Nov 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) account for ~80% of supply, and top 100 holders account for ~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 less than $100 of UNI-V1-USDC-ETH deposited as collateral, demonstrating a very 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-USDC-WETH had ~$200,000 in TVL, with around $100,000 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 USDC stays stable around $1, a decline in the price of ETH will lead to a corresponding decline in the price of UNI-V2-USDC-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-USDC-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-USDC-ETH loss = -0.293

50% drop in ETH price leads to 29.3% drop in UNI-V2-USDC-ETH value, assuming no change in USDC price and excluding any positive fees earned by LPs. The relationship between ETH and UNI-V2-USDC-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-USDC-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 100% 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 UNI distribution incentivized deposits to UNI-V2-USDC-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.
  • LP tokens are vulnerable to custody and credit risk of USDC. LP shares could face serious decline in value if USDC lost its peg. If Centre blacklisted or froze the USDC-ETH Uniswap pool, all assets in the pool would be unrecoverable.
  • UNI-V2-USDC-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-USDC-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-USDC-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



Is the USDC custody risk is no longer priced (I see it in the text but not in the RP)? I think it was the main reason to have a RP of 4% for USDC in the first place. The tail risk is almost the same here.


UNI-V2-USDC-ETH is impacted by USDC custody risk, but the higher liquidation ratio vs USDC-A vault helps mitigate this somewhat.

With respect to insolvency or credit risk, USDC price would only need to fall ~1% for USDC-A vaults to start experiencing losses. But with UNI-V2-USDC-ETH at a 125% liquidation ratio, USDC price would need to decline by ~36% (assuming constant ETH price) before Maker loses money.

With respect to regulatory risk, if USDC in UNI-V2-USDC-ETH was frozen, it would render all assets in the pool as unrecoverable. But this may pose a lower risk than USDC-A vault as well, because Maker would still have the option of selling the LP tokens, while a freeze of the USDC adapter would leave Maker with no options for liquidation.

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In case of usdc freeze.
What the value of this token if you can’t withdraw usdc either weth, as they are coupled. I believe you can’t even swap token.

It is fair to assume the token has no value.

On the other hand we have 400M + 400M to absorb.

While a USDC freeze on UNI-V2-USDC-ETH would make it impossible to withdraw the underlying USDC or ETH from Uniswap until Centre lifted the blacklist, the LP token itself can still be transferred. Presumably some investors would be willing to purchase it at a discount vs underlying value, assuming that the freeze would eventually be lifted.

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Good work, thanks @monet-supply. Just another short comment from my side, same as for UNI-V2-DAI-ETH:
“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.”

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