[UNI-V2-WBTC-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: 2%
Liquidation Ratio: 150%
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

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-WBTC-ETH is the Uniswap LP token consisting of WBTC 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 ETH-BTC pair.

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-WBTC-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-WBTC-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-WBTC-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 (~91%) 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 has ended as of November 17 and there was an outflow from the staking contract into individual wallets. The top 10 addresses in the UNI farming contract held approximately ~56% of the total supply of UNI-V2-WBTC-ETH as of November 10, but this number was likely skewed by yield aggregators increasing ownership concentration. Currently, the top 10 holders own ~66% of supply, while the top 100 own ~90% of supply.

Source: Nansen, Nov 2020

AlphaHomura is a yield farming platform which allows users to lever up in LP token positions to earn higher returns by borrowing ETH. Currently, the farm based on UNI-V2-WBTC-ETH had ~$3,000,000 million in TVL, with around $1,500,000 in ETH 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.

A decline in the price of ETH or WBTC will lead to a corresponding decline in the price of UNI-V2-WBTC-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-WBTC-ETH percentage loss = loss from existing holdings + divergence loss

Loss from existing holdings = ETHUSD percentage price change * ETH allocation (50%) + BTCUSD percentage price change * WBTC allocation (50%)

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

E.g. if ETH price suffers 50% price drop while WBTC 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-WBTC-ETH loss = -0.412

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

Uniswap v2 has only been live since May, but based on the past 5 years of ETH and BTC price history and Uniswap’s invariant formula, UNI-V2-WBTC-ETH would have experienced significantly fewer sharp drawdowns than ETH. 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: 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 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-WBTC-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.
  • 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 WBTC-ETH 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-WBTC-ETH will suffer from divergence loss when ETH or BTC 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-WBTC-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-WBTC-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: 2%
Liquidation Ratio: 150%
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