I know this was posed before by @mattdw but I want to re-introduce this where I’ve gone through this more thoroughly and added some modifications. I’ve quantified the impermanent loss risks below so people can better understand them. I think we should develop IL strategies and over time improve the IL hedging perhaps with options. For now I present the below:
Proposal yETH Strategy:
This is a ETH/DAI Uniswap farming strategy using the yETH vault although this could also work for the yWBTC vault. As you can imagine the flow is:
- User deposits ETH into yETH vault:
- Some % of ETH goes to MKR vault (Based on Strategy Collateralization Ratio – I am proposing 250%)
- DAI is generated in MKR vault subject to Strategy Collateralization which should equal the value of ETH not deposited into the MKR Vault. See the example below using 10k ETH deposited at a $400 ETH/USD price:
- All farmed UNI is converted into ETH is held separately and is incorporated in any subsequent rebalance event. If no rebalance, just accumulates as ETH profits.
As mentioned above this strategy clearly has impermanent loss risk. There are a few constraints that we have to work with:
- We have DAI debt that can’t breach the MKR collateralization ratio floor of 150%. Once we get close to that level a rebalance in required.
- The other is that we would prefer to not rebalance as that crystalizes impermanent loss. We need to set the Collateralization high enough that it gives us room where the ETH/DAI ratio can float without being forced to crystalize impermanent loss (particularly to the downside). I am proposing to rebalance on an upside move of equal magnitude, but that is an (open question). Based on a 250% collateralization ratio we can incur a 40% decline (and 66.6% upside) and not have to crystalize impermanent loss. See the downside example below. This would imply a $240 ETH price down and a $666.66 ETH price up. The impermanent loss is 3.17%, but only on the Uniswap notional amount (not the full vault size). This equates to a $58,065 or 241.94 ETH ($58,065 / 240 USD/ETH price) permanent loss once rebalanced.
Once the MKR vault breaches the 150% threshold (or we can set how close we are comfortable) we now have to rebalance. A rebalance to 250% will look like the below. The total position is calculated in terms of a Net ETH position and the process is started again as if that amount of ETH was originally contributed to the vault. The net changes are made below to effect the rebalance. In this example 172.81 ETH is withdrawn to from the MKR vault and converted to 41,064 DAI which then pays down the DAI debt. 901 ETH and 213,989 DAI is withdrawn Uniswap. The 901 ETH is converted into 213,989 DAI. The combined 427,978 DAI is also used to pay down DAI debt and then we are fully rebalanced.
Based on a $3.00 UNI price and $50k in daily fees in the ETH/DAI pool and a 2% DAI annual interest rate we should generate approximately a 15% annualized return before accounting for impermanent loss.
Given we have a 40% downside and 66% upside range where we aren’t crystalizing impermanent loss that should give us plenty of room to earn before having to rebalance. We can make the range bigger but at a cost of lower annualized return (due to higher collateralization ratio hence smaller Uniswap pool) and a risk of a larger crystalized impermanent loss at given a wider range. I think 250% strikes the right balance. At a 40% downside we would crystalize a loss of 241.94 ETH which is approximately 2 months of farming. At a gain of 66% we would lose 145.16 ETH which is approximately just over 1 month of faming. We could have some combination of 6 downside rebalances or 12 upside rebalances where we would lose money break even. The main risk would be a massive gap risk to the downside where we couldn’t rebalance at our designated 40% downside but ended up being much lower than that.
The only time DAI liquidity becomes an issue is when we have to rebalance to the downside we need to sell ETH to generate DAI to pay down the debt. Just a matter of how much price impact there is. We can mitigate this by making sure we are not bigger than a certain percentage of the Uniswap pool. For example if we had 1,000,000 ETH ($400,000,000) in the vault initially at 400 USD/ETH, on a 40% downside event we would need to sell 107,335 ETH for DAI to rebalance. This equates to ~25.5mm DAI. Our existing uniswap position (not counting the rest of the pool) would have ~67mm DAI so the DAI would be there its just a matter of the price impact of the rebalance. Maybe someone can help model that to determine what % of the uniswap pool we should be to not generate an adverse price impact on the rebalance.
- What should the MKR Collateralization ratio be? I propose 250% since it gives room to float down 40% and up 66.66% from initial ETH price before any action is required.
- Do we want to rebalance to the upside and if so at what increments? I propose yes at 66.66% upside relative to last rebalance.
- When we rebalance from a 150% MKR vault collateralization do we want to rebalance back to 250% or to some lower number? I propose 250%
- In order to allow continuous deposit and withdrawals I believe you need to unwind a slice of the vault meaning unwind their percentage of the uniswap LP pool, pay down their proportion of debt and return their NET ETH position. Likewise contributions would need to generate DAI in the MKR vault to maintain the current (not initial) collateralization ratio and then contribute to uniswap proportionally. I think this needs to be done to make sure impermanent loss is not shifted between different yETH vault contributors. Can someone confirm this? Is there a better way to handle deposits/withdrawal?
- Should we limit the strategy to some percentage of the total Uniswap pool? I’m not opposed to being no more than 20% of the Uniswap pool to mitigate price risk on downside.
- Happy to have someone check my calcs as well.
Let me know what you all think.