Delta-neutral ≠ risk-free. How Resolv mitigates architecture-specific risks

Project architecture

Nov 20, 2023

Introduction

At Resolv Labs, we’re pioneering a novel stablecoin framework with our True Delta-Neutral architecture. This approach diverges significantly from traditional fiat-backed or CDP stablecoins (like DAI or Liquity). We already highlighted the benefits of the design in our introductory article, so let us take a critical look at the other side — dive into the risks unique to our model and strategies for mitigating them.

Resolv treasury leverages futures contracts. They are traded on exchanges, and centralized exchanges have dominating liquidity for now.

TDN design immediately adds a benefit of delta-neutrality. Long spot and short futures positions set off each other to create a stable portfolio in dollar terms.

Ether price and profit/loss of corresponding perpetual futures, last 12 months

However, such reliance on price hedging also adds exposure to credit, liquidity and rates risks. We wrapped all this in a form of Q&A below.

Credit risk

Q: Resolv integrates with CEXes and perpetual DEXes for hedging with futures. What happens if a trading venue is insolvent, or a DEX protocol gets exploited?

A: Credit risk in trading venues is a critical concern. We have seen how FTX fell into insolvency just a year ago.

Even good-faith trading venues can become insolvent as a result of severe price changes causing multiple cascade liquidations.

How does Resolv approach counterparty exposure? There are three main risk mitigation layers:

  • Resolv will hold collateral outside of the CEXes. It will integrate with institutional custodians allowing to use assets placed outside of the exchange as collateral for the futures, thus eliminating counterparty risk in relation to collateral;

  • Resolv prioritizes diversification. We will seek to connect to all reasonable sources of futures liquidity. But that’s not it. We care about risk management more than about tracking down better funding rates. To be precise — Resolv upholds single counterparty exposure limits on a protocol level. Hedges are maintained so that the weights of each venue follow target allocation;

  • Most importantly, centralized exposure will be isolated in the protection layer (RLP). It means that default of an exchange will not affect USR, the stablecoin layer. This is one of our key unique elements vs other designs.

Price risk

Q: Is Resolv truly delta-neutral?

A: Yes, USR and RLP are at all times backed by the perfectly delta-hedged position in ETH and short futures. In fact, when user mints or burns our tokens, it results in execution of the futures position adjustment, and such hedges work for any change in Ether price, be it 200% up or 90% down.

We are not mixing in additional leverage, pseudo delta-neutral hedging, linkage to other stablecoins, or other risky exposures in order to seek higher yields. The core of the strategy is delta-neutral by construction.

Q: But the treasury allocates only a fraction of reserves to collateralize futures. It means that in case of material price movements it could get instantly rekt. How does Resolv address risk of swift price action events?

A: Even though only a part of assets will be delegated to the exchanges as margin, Resolv exposure to futures is fully covered by these assets at all times. It means that for centralized venues there is no reason to liquidate positions that are fundamentally backed up with collateral. We will be working with exchanges to confirm terms allowing to top-up collateral from on-chain treasury without liquidations. Watch this space!

However, the protocol cannot rely on such “no liquidation” concept alone. Our architecture will always be rebalancing and maintaining enough collateral even in events of sudden swift appreciation in ETH price. We model such sufficient amount of collateral based on price surges and the conservative latency of collateral top-ups. Model updates will be carried out regularly to calibrate this metric and other related metrics based on fresh market data.

Liquidity Risk

Q: When user redeems Resolv tokens to get back ETH, Resolv closes relevant number of futures positions. Quantity of ETH returned to the user is determined by unwind price of these positions. In extreme market scenarios, will there be enough futures liquidity so that slippage is negligible?

A: Liquidity crunch can affect any market, including crypto spot and futures markets. How would it happen in this segment in particular? Typical scenario in global spot markets is that price actions cause cascade liquidations, which in turn result in futures liquidity getting dried up.

Mint & burn activities during such events would result in execution of open market trades with higher slippage. It means that, for example, a user would need more ETH to mint USR tokens just because executable average ETH price slips from current market price.

As this risk is carried by the users willing to execute significant liquidity shifting trades, we would advise them to time their activities accordingly at times of less liquid market. For example, it would be reasonable to mint or burn substantial amounts of tokens in more stable market situations. From the contributors side, we will be working on providing users with information related to slippage in user interface, to help them make better informed decisions.

For the avoidance of doubt, slippage effect does not affect current positions backing USR and RLP.

Q: Why are you sure that there will be sufficient liquidity in the protection layer to cover the losses?

A: First of all, the protection layer has a self-balancing economical mechanism. The thinner the protection layer (TVL ratio of RLP to USR), the higher returns RLP provides. Thus, users are incentivized to provide liquidity into the protection layer when it becomes thinner.

Still, this stabilization mechanism in itself does not prevent short-term uncertainty which typically leads users to withdrawing liquidity from protocols. To protect USR users and provide stability, the protocol uses Target Capital Adequacy approach — if liquidity in RLP drops to a specific threshold, the protocol will be suspending new stablecoin mints (but not withdrawals) to keep on-chain backing in check. It will also pause redemptions of RLP until Capital Adequacy ratio returns to base line. However, RLP holders will be able to sell RLP on a secondary market if they are willing to dispose of their positions.

Rates Risk

Q: Negative funding rates of the futures positions can offset Ether staking profits and lead to net losses for Resolv. How do you tackle this concern?

A: True, at times even for very liquid ETH and BTC futures funding rate swings can be violent, when significant price actions misplace spot and futures prices. This can lead to losses of delta-neutral strategies.

Historical funding rates for inverse perpetual ETHUSD futures. Data: Binance, Deribit

Historical distributions of funding rates have positive mean values (for instance, the APYs of 8-hour funding rates at Binance and Deribit are 5.39% and 0.04%, respectively, for the past 30 months). But they are negatively skewed, with strong outliers. In Resolv case, let us see how RLP, the protection layer, covers this exposure.

  • All-time minimum 8h funding rate for ETH at Binance was -0.35%, while at Deribit was almost -0.6%. RLP would absorb such loss easily as it would represent only 3–4% of its value on average.

  • But what about longer term exposure? It would take 60–90 days of extreme — minus 40% p.a. — funding rates to drain the protection layer. Such long-term rates drop never happened due to arbitrage principles. Arbitrageurs would be able to put on a risk-free double-digit yield strategy utilizing such negative basis.

  • All that said, even during substantial funding rate hits, only RLP will be affected, and USR as the stablecoin will maintain its 100% collateralization.

Closing thoughts

In stablecoin design, no setup can be considered truly risk-free. However, a reasonable approach in building a robust structure is to:

  • Minimize the risks by construction;

  • Isolate residual exposure into competitively priced investment instruments relevant for risk-conscious users.

Resolv does exactly that. We’re not only focused on minimizing risks discussed above, but also manage other aspects, from smart contract risks to regulatory challenges.

RLP, as a protection layer, is designed to be an investment instrument that market participants invest into in exchange for leveraged protocol revenue-sharing.

Our commitment is to continuously evolve and enhance the protocol’s strategy to maintain the highest standards of stability and security in the crypto market.

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We hope it was useful! For further insights into what we are building, follow us on Twitter and check out https://www.resolv.im/