[UNI-V2-WBTC-DAI] 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: 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: 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-DAI-WBTC is the Uniswap LP token consisting of WBTC and DAI. The pool currently has low liquidity of less than $10,000. But there is a highly liquid WBTC/USDC pool with over $7 million in deposits, and some of these users may be interested in moving their positions over if Maker offers borrowing capacity.

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-WBTC 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-WBTC 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-DAI-WBTC 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.

There are not currently any defi platforms offering borrowing capacity or integrating the UNI-V2-DAI-WBTC LP token, or any other BTC/USD LP tokens.

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

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

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

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

E.g. if WBTC 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-DAI-WBTC loss = -0.293

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

Uniswap v2 has only been live since May, but based on the past 5 years of BTC price history and Uniswap’s invariant formula, UNI-V2-DAI-WBTC would have experienced significantly fewer sharp drawdowns than BTC/WBTC individually.


Source: Coinbase, Feb 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.

Annualized fee earnings in the Uniswap WBTC/USDC pool (the closest analogue with significant liquidity) have fluctuated between 10% and 60% over the past 3 months, with around 40%average annualized returns since early January.


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.

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.
  • LP tokens are vulnerable to custody and credit risk of WBTC. LP shares could face serious decline in value if WBTC lost its peg. If Bitgo blacklisted or froze the DAI-WBTC Uniswap pool, all assets in the pool would be unrecoverable.
  • BTC is a bearer asset, so WBTC faces higher custody risks from potential hacking or insider misconduct than comparable USD stablecoins.
  • UNI-V2-DAI-WBTC will suffer from divergence loss when BTC 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 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-DAI-WBTC.
  • 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: 3%
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: 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:

7 Likes

Minor point, is the ticker UNI-V2-DAI-WBTC or UNI-V2-WBTC-DAI ?

The oracle and SC are wbtc/dai.

It’s the one on chain.

3 Likes

I’ve been making a convention of LPs including DAI listing DAI first (eg UNI-V2-DAI-WBTC), and LPs including ETH having ETH second (eg UNI-V2-WBTC-ETH). But whatever goes on chain is canonical.

1 Like

Can you take the ordering from uniswap.info, please? The order there matches the order on-chain and it makes the most sense to follow that convention.

1 Like

100%, will do going forward :slight_smile:

1 Like

Ideal convention would be BASE/QUOTE, where base is the traded asset and quote is the asset used for pricing. I know this breaks down for uniswap but for me it makes more sense that wbtc is being traded and dai is used for pricing.

That said, we should follow whatever uniswap is doing

Yes, we don’t have the hand on how uniswap pairs are created, tho there is an order I believe based on the contract address I think.

1 Like