Decentralized New Betting Tool: Risk Study of the f(x) Project

Preface

The four-year cycle of the cryptocurrency market is truly fascinating. Each time, it feels different, but the outcome is always the same. I’ve never been fond of predicting the market, buying altcoins, or trading with leverage. However, despite my preferences, I still find myself caught in the traps of each bear market cycle. The slightest greed in one’s heart is enough to lure them into similar pitfalls, just like the altcoin crowdfunding in 2013, the ICO craze of 2017, the DeFi summer of 2020, and the aggressive deleveraging of my CDP during the two crashes in 2021.

To me, the right way to break free from this endless crypto cycle and steadily grow wealth is by imprisoning one’s greed within the pre-set rules of DeFi, using pure mathematical derivation and code implementation. This automation of financial protocol functions is truly wonderful. The series of products by @aladdindao follow the same philosophy, which can be seen in my previous articles.

As the fourth product of @aladdindao, f(x) uses a few simple mathematical equations to create a novel product for Ethereum’s DeFi ecosystem - a structured product similar to a tranche in finance. It splits the underlying asset, stETH, into a certain number of stablecoin-like products, fETH, and high-volatility, high-return leveraged products, xETH. These two types of assets based on Ethereum cater to two market demands: risk aversion and leverage demand.

1. Leverage demand scenario

Suppose the market is at the end of a bear cycle and the beginning of a bull cycle, indicating a significant potential rise in underlying assets like Ethereum in the coming years. For coin hoarders, patience is all they need. But for leverage enthusiasts, why not take a bigger risk with some leverage if the market upturn seems certain? However, we know that short, intense downturns are common during bull markets. The challenge for leverage users is surviving these moments before dawn. Moreover, most of the time, the funding rates of perpetual contracts on centralized exchanges charge for long positions, making it uncertain whether the returns can cover the funding rates.

Ethereum Perpetual Contract Funding Rate Distribution

But imagine a product that allows you to hold leverage while avoiding the imminent risk of liquidation, with zero or even negative funding rates and low holding costs. Wouldn’t many coin hoarders be tempted to add a bit of leverage to enhance their returns?

2. Risk Aversion Scenario

On the other hand, during a bull market with soaring prices, you have a clear risk aversion need but don’t want to convert to stablecoins and miss out on potential growth. Besides, every stablecoin has had its moments of FUD. What you need is something like fETH - an Ethereum-based asset without external risks from Real World Assets (RWA) - to reduce the overall volatility of your assets.

Imagine if Ethereum’s price plummets by 90% after you mint fETH (a scary thought), but your fETH only causes you a 9% loss. You just dodged a super bear market, making it a perfect strategy for “not giving up the last penny.” At this point, I’m quite tempted. After all, the security level of native crypto assets is much higher than various mining LP-wrapped assets. However having experienced numerous setbacks, I know that no protocol is all benefits without costs. I need a complete understanding of the protocol’s risks before making a real money decision.

f(x) Protocol’s Three Key Questions

How does the f(x) protocol achieve asset volatility grading, how stable is the system under extreme market conditions, and where is the system’s breaking point?

1. Principle of volatility classification

Understanding the f(x) protocol involves looking at the following dashboard. The underlying asset ETH is staked as stETH through Lido and then split into a certain number of stablecoin-like assets, fETH, and leveraged assets, xETH. fETH has only 10% of the volatility of the underlying asset, while xETH bears the remaining volatility.

The essence of the protocol lies in the following simple formula:

We see that the underlying asset of the protocol is 2698.868 ETH, with a TVL (Total Value Locked) of $4,889,229. This TVL equals the sum of the NAV (Net Asset Value) of the two decomposed assets, namely the fETH market cap + xETH market cap. The price of fETH is fixed at 10% of Ethereum’s price fluctuation. Thus, with the fixed prices pf for fETH, and constant quantities nf and nx, we can calculate the price px.

Let’s clarify with an example:

Initially, a user uses 1 Ethereum worth $2000 to mint 1000 fETH and 1000 xETH. The next day, Ethereum’s price fell by 10% to $1800. According to the protocol, fETH can only fall by 1%, bringing its price to $0.99. Using Formula 1, we find that the price of xETH becomes $0.81. The volatility rate of xETH is then (1-0.81)*100% = 19%, corresponding to leverage of 1.9 times.

18001=0.991000+0.81*1000

From the fluctuation curves of different assets on the dashboard, it’s apparent that fETH fluctuates minimally, while xETH’s volatility is greater than that of ETH itself. The project could make the UI more intuitive here.

2. Ensuring System Stability

The first law of f(x) stability: The volatility rate of the quasi-stablecoin fETH always precisely stabilizes at 10% of ETH’s volatility.

First Corollary: To satisfy the first law, there must be a sufficient amount of leveraged xETH to absorb the excess volatility of the underlying assets beyond the quasi-stablecoin fETH. If the quantity of xETH is relatively small, then the leverage of xETH needs to be increased to absorb volatility (see the right side of the diagram in red). If there is a large amount of xETH, the leverage is reduced (see left side of the diagram), whereas a lower leverage can dilute volatility.

These two simple rules form the basic conditions of the f(x) protocol. However, this curve is not a spontaneously stabilizing financial system. Extreme situations on both sides of the curve need special attention:

(1) Left end of the curve: An excess of leveraged xETH relative to quasi-stable fETH. This situation is likely more common in a bull market, where more people prefer leveraged products over stablecoins. In extreme cases, the leverage of xETH could drastically fall close to 1, making it similar to holding native Ethereum assets. However, this doesn’t harm the overall protocol, as the system will automatically return to the middle of the curve.

The f(x) whitepaper also mentions that although the demand for fETH determines its supply, to meet demand at any time, the amount of fETH that can be minted at the lowest cost is usually much higher, limited only by the supply of xETH.

The protocol could implement a space for operations similar to the FRAX protocol’s AMO (Algorithmic Market Operations). For instance, if the growth of xETH causes the leverage to be too low, reducing its market appeal, the f(x) protocol could actively issue more fETH, maintaining a leverage ratio of, say, more than 1.5 times. It could then address future decreases in xETH demand by destroying this additional fETH, minimizing spikes in leverage.

(2) Right end of the curve: A shortage of leveraged xETH relative to stable fETH. This scenario is more dangerous for the system and needs to be guarded against, as it usually occurs when the market is extremely pessimistic, with continuous price drops and a general preference for stability. In such cases, as seen in the curve, the leverage of xETH experiences a steep increase, potentially creating a fatal negative death spiral: less inclination to leverage — higher leverage multiplier — even less inclination to leverage…

In this situation, the free market cannot spontaneously resolve the issue. Fortunately, the f(x) protocol has methods to prevent such a tragedy.

3. Risk Boundaries of the f(x) Protocol

The f(x) protocol introduces a concept in the CDP lending protocol - CR (Collateral Ratio) margin ratio. From the perspective of the agreement parties, the underlying assets pledged by users in the protocol are collateral, and the minted stable currency fETH is borrowed. The protocol must ensure that the value of the loaned stable currency cannot exceed the value of the collateral, that is, CR>100%, otherwise bad debts will occur and the loan will become insolvent. The value of xETH is not calculated here because in extreme cases xETH may return to zero, but even so, the protocol must ensure normal operation and avoid bad debts.

The f(x) protocol used daily Ethereum price changes since January 1, 2017, for calculations. When the probability of risk occurrence is no greater than 0.1%, this is equivalent to a 25% drop in Ethereum in one day. In one case, under this level of disaster, a CR of 130% is completely withstandable, so the protocol sets a CR of 130% as a safety threshold. Below this threshold, stability mode is automatically activated. At this time, the value of the corresponding stable currency fETH exceeds 0.78 times the value of the underlying assets, and the leverage ratio of xETH reaches exactly four times. In stable mode, the measures taken by the protocol are:

(1) Control protocol entrance and exit

The f(x) protocol controls the minting and redemption fees of fETH and xETH and even stops the minting of fETH. The purpose is to increase the value of xETH relative to fETH and improve the protocol’s ability to absorb the volatility of the underlying assets.

(2) Internal asset rebalancing——Rebalancing Pool

Similar to the stability pool of the Liquity project, the protocol encourages fETH holders to place their coins in the protocol’s pool to earn a certain amount of pledge income, and the protocol has the right to use these assets to redeem fETH when the CR is below the safety threshold. Back to the reserve asset, namely stETH.

fETH holders with hedging needs can use the Rebalancing Pool to increase their income while significantly reducing their fluctuations, and the protocol, by guiding incentives, includes fETH as its protocol liquidity in a short time (the latest change has changed from lock-in to Two weeks turns into one day of lock-in), thereby effectively adjusting the CR value of the protocol to run away from the risk.

Of course, if the assets in the Rebalancing Pool are exhausted and CR is at risk of continuing to decline, the f(x) project will use the protocol revenue to incentivize xETH minters.

Different from liquidity, the income obtained by the liquidity provider of the Rebalancing Pool comes from outside the protocol, that is, the Ethereum pledge income of the lido protocol, while liquidity completely uses its token emissions as incentives, which also results in the $LQTY token Long-term selling pressure on the currency, but this is also the price it must pay for using the purest native token ETH.

In my opinion, the f(x) protocol can still learn from the practice of liquidity. After the CR is lower than 130%, the redemption process of fETH can receive a certain reward similar to the liquidation income, to encourage more fETH to enter the Rebalancing Pool.

This is different from the situation of the stable currency used. The most important function of the stable currency is the circulation function, while the important function of fETH is the hedging function when held. In essence, it does not require much circulation in the market.

(3) Agreement treasury income subsidizes xETH minters

If using the Rebalancing Pool is to increase CR by shrinking the TVL scale of the protocol, subsidizing xETH minters is a more positive way to increase TVL to increase CR. The specific intensity and actual effect of subsidies still need to be tested in actual combat.

Users’ decisions under extreme market conditions

risk-averse

For holders of the stable currency fETH, if you put your fETH into the Rebalancing Pool, you need to pay attention to whether the CR will drop below 130%. If this happens, you should withdraw from the pool in time. The latest modified lock-up period is only one day. time, very user-friendly. However, for the protocol, large-scale liquidity withdrawal is bound to have a serious impact on the security of the protocol.

For users who truly seek stability, it is safest to keep fETH in hand to avoid possible forced redemptions. But if it reaches the extreme boundary of the agreement - CR=100%, the volatility of fETH will be equal to the volatility of ETH. This risk is not unbearable. After all, the epic drop will probably be almost over at this time. , the asset has escaped the most significant decline stage.

leverage player

For leverage players, if the leverage ratio is very low, the fun will be lost. However, it is not a big problem. If the CR drops below 130%, the leverage ratio will surge. At this time, it will inevitably be accompanied by a sharp decline in market conditions and losses. That’s called a thousand miles. If you want to redeem it, you have to bear an 8% fee. When the CR approaches 100%, that’s when xETH returns to zero.

But what I want to analyze is that when the market drops sharply, quasi-stable currency holders and leveraged currency holders or minters are not static in holding the currency. There is a game balance between them… When CR approaches 100%, holding fETH loses its meaning. With an additional layer of contract risk, some users will naturally choose to redeem the underlying asset ETH and hold ETH at a low level. At this time, the xETH leverage ratio will soar to 20 times or even 100 times. At this time, the risk-return ratio has completely shifted to the side of leveraged players. A little investment may be exchanged for 100 times returns. Will no one come to offset it? , I don’t believe it. This will cause a gradual increase in CR and return the system to stability.

The formula for calculating the leverage multiple of xETH in the f(x) protocol

Through the leverage formula of the f(x) protocol, we can calculate the table of leverage ratios under different proportions of fETH to total assets.

The leverage ratio explodes rapidly as the proportion of fETH increases

Therefore, CR will not reach 100%, because the leverage cannot be infinite, and 100% CR is a mathematical limit concept. From this point of view, this system has its inherent ability to return to stability. Of course, this is just a purely theoretical analysis. The real market trends and the operation of the protocol in a stressful environment may not necessarily be what I say.

Another external risk to the protocol that cannot be ignored is the decoupling of stETH due to lido problems or other reasons. If the difference between the price of stETH and the price of ETH exceeds 1%, the protocol will temporarily stop minting coins. Redemptions are still normal, but fETH redemptions use the higher of the two prices (stETH, ETH) and xETH redemptions use the lower price. This also protects the interests of holders of the stablecoin fETH.

Conclusion

After a bunch of analysis above, the official propaganda of “xETH is the first ever levered ETH you can HODL” is true. The current price of Ethereum entering stable mode is $1078, the CR of the protocol is 207%, and the protocol has A relatively large safety margin.

In my opinion, the greatest significance of the f(x) protocol is to provide a decentralized financial tool for users with different risk preferences, allowing users to completely stay away from centralized exchanges, remove real-world asset risks, and rely entirely on Cryptocurrency native assets can fully display their strategies and truly become the masters of their assets. This is in line with the spirit of Satoshi Nakamoto and is also the greatest significance of the emergence and existence of DeFi.

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