A Comprehensive Analysis of Delta Neutral Stablecoins and Related Projects

In July 2023, the well-known decentralized stablecoin project, Liquity, unveiled the preliminary concept for its V2: to achieve a 1:1 hard peg between circulating stablecoins and their collateral via the Delta hedging strategy, with a projected launch in Q2 of 2024. Around the same timeframe, Ethena—inspired by Arthur Hayes and also in the process of developing a Delta Neutral stablecoin project—received support from several leading CEXs in the industry.

Currently, both Liquity V2 and Ethena are in their nascent stages, with many technical details yet to be disclosed. However, seizing this opportunity, this article offers an initial analysis of decentralized stablecoin projects in DeFi that utilize derivatives for hedging.

Understanding Delta Neutral Hedging:

Before diving deeper, let’s first briefly introduce the concept of Delta Neutral hedging.

“Greeks” are widely-used risk management tools in modern finance, derived from the option pricing model known as the Black-Scholes-Merton Model (BSM). They measure the sensitivity of option values to changes in parameters within the BSM, such as the underlying asset price, volatility, and the time remaining to expiration.

Among the Greeks, “Delta” represents the first-order partial derivative of the option price with respect to the underlying asset price. In essence, it quantifies the sensitivity of the option price to changes in the price of the underlying asset, with a value range between [-1,1]. For instance, the Delta of a call option is always positive. If the price of stock A increases by 1 dollar and the associated option price also rises by 1 dollar, this implies a Delta of 1. Conversely, the price of a put option increases when the price of A decreases, indicating a negative Delta.

Though the strict definition of Greeks is based on the BSM and is specifically for options, this concept has been extended and applied to portfolios and other derivatives, such as futures contracts. The actual meaning depends on the specific context in which it’s used.

Delta Neutral hedging is a portfolio risk management strategy. Being “Delta Neutral” means that the overall value of a portfolio is unaffected by changes in the price of the underlying asset. Practically, it involves combining financial instruments with different Delta values so that they offset each other. For instance, both futures contracts and spot contracts have a Delta of 1. By shorting 1 unit of futures and going long on 1 unit of spot contracts, the resulting portfolio Delta would be zero.

Problem Description

The Liquity team has accurately distinguished between two types of stablecoins:

• Collateralised Debt Position (CDP): Each borrower’s position is independent, with over-collateralized assets, lending out stablecoins corresponding to their individual positions.
• Decentralised Reserve Protocols (DRP): Users deposit in the protocol’s reserve pool and exchange for an equivalent value of stablecoins.

The core concept of a DRP stablecoin aligns with the general centralized (based on off-chain assets) reserve-backed stablecoin: The stablecoin and the collateral must maintain a 1:1 exchange relationship, meaning one unit of fiat stablecoin can always be exchanged for one unit of fiat collateral.

The market value of circulating stablecoin as，and the value of the reserve pool as， DRP aims to satisfy

However, collateral valued in fiat currency is always fluctuating, and the value of collateral in the reserve pool is directly impacted by market changes. Suppose a user deposits $10,000 worth of BTC and exchanges it for an equivalent value of stablecoins. If the price of BTC rises to $20,000, while there’s $10,000 worth of stablecoin in circulation, the reserve pool would have an excess of $10,000 worth of BTC collateral, making the stablecoin protocol very secure. However, if the BTC price drops from $10,000 to $5,000, even though the quantity of BTC in the reserve remains unchanged, its market value is halved. Yet, $10,000 worth of stablecoin still circulates in the market, implying that half of the stablecoins are unsupported by collateral. Under such circumstances, if users massively redeem their collateral, it could result in devastating bad debts for the protocol.

In CDP, individual borrower positions absorb market fluctuations independently. In DRP, only the protocol absorbs market fluctuations, concentrating the risk.

To maintain the value of collateral in the reserve pool, one method is hedging: as the value of the collateral decreases, other values flow into the reserve pool, ensuring the overall value of the pool is equal to or greater than the market value of the issued and circulating stablecoins.

In the market, there are two primary Delta hedging routes:

• UXD Protocol, Pika Protocol, and Ethena:
• Angle Protocol and Liquity V2

UXD Protocol, Pika Protocol, and Ethena: This route divides the value of the reserve pool into collateral spot positions and corresponding short reverse contract positions. The protocol uses the spot as margin to purchase an equivalent value of short reverse contracts, so the Delta hedge offsets the margin and the short contract, resulting in a net position close to zero. This means the value of the position remains unaffected by the spot price of the collateral. According to available sources, this approach originated from Arthur Hayes’ concept of NakaDollar (NUSD).

Angle Protocol and Liquity V2: Though also employing a spot + contract hedging method, the details differ from the first route. In Angle Protocol and Liquity V2, individual users or groups purchase long contracts of collateral tokens in the built-in derivatives market, with the protocol acting as the counterparty. When the market goes down, the price of the collateral drops, causing a decrease in the reserve value of the protocol, while the long contracts result in a loss. At this point, after liquidating or forcibly closing the long contracts, the lost margin becomes additional collateral for the protocol. This behavior of the protocol is similar to selling call options to earn option premiums.

UXD Protocol and Ethena

UXD Protocol

In 2021, the stablecoin project UXD Protocol on Solana implemented a mechanism of hedging stablecoins with equivalent collateral using a double leveraged short perpetual contract. This is strikingly similar to the NakaDollar discussed by Arthur Hayes in his earlier blog post titled “All Abroad!”.

In September 2021, led by an investment from Multicoin Capital, UXD Protocol raised $3 million in its seed funding round.

The principle of UXD Protocol is as follows:

• Suppose there’s a trading pair ETH/USD, with the ETH priced at $1000 USD each.
• When a user deposits 1ETH into the UXD Protocol, they receive 1000UXD for circulation in the market.
• The protocol takes this 1ETH as collateral and purchases a bearish reverse perpetual contract for 1ETH from the derivatives market.
• Now, the protocol holds both the spot position of 1ETH (in the form of collateral) and a short position of 1ETH. This combination is always valued at $1000, unaffected by changes in the price of ETH, maintaining Delta neutrality.

It’s imperative to note that this mechanism is built on inverse contracts, commonly known as coin-margined contracts. Spot plus USDT-margined contracts cannot achieve the Delta-neutral hedging envisioned by Hayes.

1: Workflow of the UXD Protocol

To maintain a balance between the perpetual contract and the price of the underlying asset, traders who hold long or short contracts need to pay their counterparty a periodic fee, known as the funding rate. When the UXD Protocol acts as the short holder of the collateral token and the funding rate is less than 0 (indicating a predominantly short market in derivatives), the protocol’s insurance pool pays the fee to the long holders. Conversely, when the funding rate is greater than 0 (indicating a predominantly long market), the protocol receives the fee paid by the long holders. A portion of this is deposited into the insurance pool, while the remainder becomes dividends for the protocol governance token holders. The specific workflow of the UXD Protocol is illustrated in Figure 1.

Challenges

Striking a balance between decentralization and liquidity is crucial when initiating external hedging contracts:

• Centralized Exchanges (CEX) offer deep contract liquidity but are centralized.
• Decentralized Exchanges (DEX) are decentralized, but their contract liquidity is limited.

This issue is one of the primary factors hindering the growth of UXD Protocol. In its early stages, the protocol’s reserve pool was entirely backed by Delta neutral positions. While this strategy boasts decentralization, high capital utilization efficiency, and price stability, it was constrained by the limited liquidity of DEX contracts (specifically, the UXD Protocol purchasing short contracts on Solana’s Mango Market). Consequently, the UXD couldn’t scale significantly. This has led the protocol to adopt a mixed asset-liability management approach, combining Delta neutral positions, over-collateralization, and RWA collateralization.

More specifically, the impact of the DEX contract’s limited liquidity on UXD is evident in the following ways:

• As the scale of the UXD Protocol grows and UXD’s short positions dominate the open interest in the contract market, the funding rate turns negative. This requires the protocol’s insurance pool to cover the costs. If the liquidity growth of the contract market can’t keep pace with UXD’s expansion, the protocol will suffer prolonged value depletion, leading to the instability of UXD. In this scenario, UXP token holders also wouldn’t benefit from shared revenue.
• The UXD Protocol requires ample counter-parties in the contract market to sell tokens, ensuring the closing of short positions and allowing users to redeem their collateral tokens. In situations of intense market volatility, is there enough liquidity to meet the redemption needs of users?

Ethena

The renewed focus on Delta neutral stablecoins stems from a series of events in the 2022-2023 macroeconomic backdrop, such as the USDC decoupling, liquidity crunches in several US banks, and increased regulatory pressures on the crypto industry, along with a new blog post “Dust on Crust” penned by Arthur Hayes in March 2023. Although the core content of NakaDollar was discussed as early as 2021, its reappearance at the “right time” has piqued the industry’s interest, including that of the Ethena Labs team.

In July 2023, Ethena Labs, a decentralized stablecoin project based on the NakaDollar concept, announced a seed funding round of $6 million, led by Dragonfly, with participation from Hayes’s family office and several renowned centralized exchanges.

Ethena plans to launch three products:

• USDe: A stablecoin based on ETH or LST spot and short contracts, minted 1:1 with USDe and redeemable against collateral tokens.
• Internet Bonds: Global network bonds based on USDe, with fixed rates derived from term-based hedging derivatives and floating rates from perpetual derivatives.
• Repo Financing: Buyback contracts for Internet Bonds.

Figure 2 depicts the minting process for the USDe stablecoin (source: Introducing Ethena Labs)

Ethena’s core approach aligns with precursors like the UXD Protocol and Pika Protocol, so we won’t delve deeper into that. The focus here is on Ethena’s enhancements to Hayes’s Delta neutral stablecoin roadmap.

Cases with the UXD Protocol reveal that Delta neutral hedging requires choices between centralized risks and contract liquidity: only markets with robust liquidity can support the growth of stablecoin scales, yet currently, only CEXs have the volume to accommodate the contract positions needed by stablecoins. Ethena’s initial solution is to sacrifice a degree of decentralization by hedging contracts across multiple CEXs.

In my opinion, decentralization has two dimensions:

Trading in one or more contract markets.
The form of the contract market: CEX or DEX.

Early versions of the UXD Protocol purchased contracts in a single DEX. This neither effectively mitigated risk (due to single-point failures) nor secured liquidity. Strategically routing contract requirements to multiple markets can help avoid single-point risks while reducing the pressure on the market from unliquidated short positions. Ethena satisfies the first layer of decentralization.

The problem with centralized contract markets is asset custody and censorship resistance. Ethena, aiming for deeper contract liquidity, has chosen to use CEXs. In the future, there is potential for a mixed model of DEXs and CEXs, but there are pressing issues of asset custody security to address. The team hasn’t disclosed specifics, which warrants attention. Moreover, with increasing regulatory scrutiny, the censorship resistance of CEXs will further diminish.

Angle Protocol and Liquity V2

Angle Protocol

In July 2021, the Angle Protocol built on Ethereum announced the whitepaper of its core module for the Euro stablecoin, agEUR. This introduced a hedging mechanism, albeit different from the Hayes approach. By September, Angle Protocol raised $5 million in a seed funding round, led by a16z.

The Core Module consists of three roles that ensure ample protocol reserves and the price anchor of the stablecoin in various ways:

• Stablecoin Holders: Can mint stablecoins and redeem reserve assets on a 1:1 basis. They can arbitrage when the stablecoin price deviates.
• Hedging Agents: Engage in perpetual contracts within the Core Module’s internal market to leverage long positions on collateral prices. As with standard perpetual contracts, hedging agents profit from leverage when the market is favorable and lose (some) margin during adverse market conditions. Angle Protocol, as the counterparty, profits from these losses, utilizing them to augment the collateral in the reserve pool.
• Standard Liquidity Providers: Offer additional collateral in exchange for protocol income and token incentives.

Figure 3: Key Roles in the Core Module (Source: Angle Protocol Docs)

The Core Module’s Hedging Agent (HA) design operates as follows:

The HA enters long contracts in the Core Module.Each margin can cover collateral already deposited in the reserve pool like.In essence, the HA’s leveraged contract profits come from the price increase of the collateralSimplistically, it’s as if the HA directly holds the protected collateral amount.

When the collateral price rises, long contracts bring leveraged profits to the HA, keeping the protocol’s collateral reserve robust. If the collateral price falls below the HA’s entry price, the HA incurs a loss. But for the protocol, acting as a counterparty, the actual loss post the HA’s liquidation is the protocol’s gain, used to supplement the reserve pool’s collateral.

The HA mechanism’s core aims to attract investors through an appealing internal (long) contract market and then use their margins to maintain the collateral value in the reserve pool. HAs only pay transaction fees, implying lower long-term costs.

Challenges

In March 2023, due to the Euler flash loan attack, Angle lost $17 million USDC in a short time, causing agEUR to decouple. Eventually, the stolen funds were returned to Euler DAO, allowing Angle to offset losses. However, this attack prompted Angle to reconsider the inherent risks of the Core Module.

Angle observed that two days before the USDC decoupling event triggered by the hacker attack, a significant number of HA contracts had been liquidated. At the same time, arbitrageurs burned agEUR, redeeming USDC at lower prices, drastically reducing the protocol’s reserves. With the hedging mechanism yet to recover, the hacker’s attack intensified the panic among agEUR holders, putting more pressure on the Core Module. While the HA of the Core Module is crucial for agEUR’s stability, it lacks resilience during extreme situations, making it hard to recover quickly.

In May 2023, Angle gradually abandoned the Core Module, reverting to the CDP over-collateralization mode. The team is now developing a basket of stablecoin price anchoring mechanisms called Transmuter as an alternative to the Core Module.

Liquity V2

The issue with the Angle Protocol’s approach is its vulnerability to external factors, such as bear market cycles. When demand for HA’s leveraged longs is low, the hedging costs become prohibitive for maintaining the stablecoin protocol.

From the available materials released by Liquity, V2 refines the Angle Protocol’s approach with some distinctions from the Hayes model. Liquity V2 introduces two innovations to address the above issues:

• Principal Protection
• Built-in Secondary Market

Principal Protection

Attracts users to open leveraged long hedges, ensuring ample reserves to maintain the stablecoin’s price during bear markets or high volatility scenarios. Even if the underlying asset’s price plummets, the V2 protocol guarantees that users won’t lose the principal used to open the contract. Principal Protection essentially derives from the premium paid by traders, which can be dynamically adjusted based on reserve collateralization and user demand.

Built-in Secondary Market

In extreme market conditions, the insurance pool might not be sufficient to protect traders’ principal. This could lead to a “run on the bank” scenario. To address this, V2 proposes a solution of incorporating a secondary market that allows for the trading of contract positions.

When supply and demand are balanced, the quoted price of contract positions in the secondary market is typically higher than the principal. Compared to liquidation, contract holders with bearish views would prefer to sell their positions to bullish investors. Transactions between these parties won’t affect the protocol’s reserve assets or insurance pool. However, during extreme downturns when supply outweighs demand, the quoted price for contract positions will be lower than the principal’s value. In such cases, the protocol’s principal protection mechanism intervenes, subsidizing the position to make it more attractive to buyers, ensuring a successful transaction. This market-oriented solution means the insurance pool only needs to cover a portion of the loss. The specifics of this subsidizing method await further explanation from Liquity.

Angle Protocol doesn’t have a secondary market. Only the protocol and HA act as counterparties. When collateral prices continually drop and market sentiment turns to panic, HA is left with no choice but to liquidate to protect the remaining principal. This causes a reduction in the reserve pool’s collateral and a value outflow from the protocol.

In Liquity V2, both the insurance fund transfers and the built-in secondary market aim to reduce the contract liquidation pressure during price declines, keeping the principal within the protocol.

Reflection and Summary

Delta-neutral stablecoins have several advantages:

• Censorship Resistance: Theoretically, if collateral is crypto-native and on-chain derivative liquidity is effectively enhanced, a stablecoin backed by 100% Delta-neutral positions can achieve maximum resistance to censorship.
• Scalability: Without over-collateralization, capital utilization becomes highly efficient. However, to mitigate risks, the reserve pool should maintain a surplus.
• Mutual Benefit with the Derivatives Market: The hedging contracts of stablecoins are major players in the external derivatives market, bringing in vast liquidity.
• Interest Earning: The interest rates from perpetual contracts can serve as a source of income.

However, past efforts have encountered challenges mainly due to:

• Insufficient liquidity in the derivatives market.
• Centralization risks in a single derivatives market.
• Decreased demand for inverse contracts, replaced by linear contracts.
• Derivative demand noticeably affected by market trends and sentiment.

The progress of Ethena and Liquity V2 deserves attention, representing two different explorative paths. Delta-neutral stablecoins are conceptually straightforward at a high level, with specific challenges to overcome, making them a key direction in the decentralized stablecoin evolution.

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