TooLazy;Didn’tRead — CDP’s are essentially a call option; low leverage CDP’s are underwriting more risk than the high leverage CDP’s; and forced sales will increase market volatility.

The unveiling of blockchain technology has been awe inspiring. It’s as if we had some kind of alien technology suddenly appear and we really don’t know what the hell it is. We know it started with Bitcoin as a decentralized currency delivered by Satoshi Nakamoto (the original alien). Then, Vitalik Buterin upped the game by putting smart contracts on the blockchain. And now, unfolding right in front of us are ‘stablecoins’. These could quite possibly be the biggest news in the cryptosphere in 2018. I have mad respect for the innovation, yet a lot of concern for the implication.

The potency of this innovation makes ‘stablecoins’ a bit of a misnomer. I say this because I believe that right now, they are being put into circulation without a clear understanding of what they actually are and they have the probability of increasing market volatility.

Stablecoins could potentially be the beginning shift of the regulatory environment against blockchain evolution. I wrote an article that blockchain technology and the transparency it provides to asset ownership and asset transfer is a gift to regulators. Remarkably, government regulators have shown a similar sentiment. CFTC, a traditionally staunch regulator, gained resounding applause from blockchain supporters when they testified in front of the senate banking committee with very positive comments about the technology.

However, stablecoins just might be where the regulators will draw the line and say “I knew I couldn’t trust you”… and it seems they can’t. In the last several weeks, more than $18 million worth of Dai Stablecoin has been issued as a loan against leveraged collateral in a smart contract with a programmed sell button that will trigger from (and exacerbate) a down market.

IDENTIFYING OPTIONALITY

For many years, I picked apart pending corporate actions in the public markets and valued them to trade arbitrage opportunities. I did this on an institutional trading desk.

My favored approach to valuation work requires distilling down elements, identify individual values and calculate a sum value. In the trading world, that wasn’t always the the best approach to navigate the markets profitably. It is far too rational. But many times, this distillation approach uncovers some very interesting hidden elements.

Example of optionality in collared merger = long call & short put

The best opportunities? Hidden optionality. The most simple and transparent example of this in the corporate action world would be a pending merger that a target company would receive a fixed value of stock from the acquiring company, but at certain stock prices above and below the current market, that fixed value turns to a fixed ratio. Optionality is an element that is most often mispriced, and in many instances, not even recognized.

INTRODUCTION OF THE STABLECOIN

I would suggest that anyone interested should first watch the MakerDAO Stablecoin introduction video and then spend some time reading their whitepaper. It is fascinating.

When I watched the movie ‘Life Is Beautiful’, I had the good fortune of not knowing anything about the movie. Not a thing. This made for a particularly powerful experience. I had a similar experience when I read about the Dai Stablecoin. I thought it would be another asset backed coin, similar to Tether which I wrote and shared a prediction, but the stablecoin ended up to be my next big ‘ah-ha’ moment with blockchain.

After reading the theory behind MakerDAO Dai Stablecoin, and what Rune Christensen has created, I now understand why a fringe group of stablecoin followers are gushing.

ALL HAIL — MakerDAO Dai Stablecoin

Essentially, the Dai Stablecoin is designed to remain at a value pinned to an underlying asset (USD) based on basic supply and demand mechanics. Dai Stablecoin is then issued as a loan against a Collateralized Debt Position (CDP). It has been in circulation for just less than two months. So far, it’s behaving well.

SO WHAT’S THE PROBLEM?

Right now, it is possible to gain 3:1 leverage (edited from 2:1) on a long ETH position. But most people don’t understand what this product actually is. The leverage and mechanics from the Stablecoin can be extremely potent, if not only specifically to each and every CDP issued, but also systematically to the market as a whole. The basic understanding that most people have is that it is a low cost loan with very little risk. Example screenshot from an enthusiastic chat room ETH investor:

Chatroom Screenshot

A couple main points worth considering:

Long Call Position : A CDP position essentially exchanges your long position for a call option on the collateral plus some Stablecoin.

: A CDP position essentially exchanges your long position for a call option on the collateral plus some Stablecoin. Systematic Risk: Program selling triggered by bear market of the underlying collateral exacerbates an already down market.

LONG CALL POSITION

CDP payoff before fees

Consider your payoff if you open a CDP position with one ETH coin worth $1,000, and you borrow $500 of Dai Stablecoin. The forced sales in this example start at $750, and designed to be an orderly sale of collateral. The payoff below the forced sale point is ambiguous depending on the sale prices, but the max loss of $500 would be the value of the original collateral, less the Stablecoin collected.

Looks like a duck, quacks like a duck….

…That’s a call option. A pretty bizarre one at that. It’s not necessarily a bad thing, but it’s important to know what it is and how it behaves. The forced sale of the collateral is designed to be smooth and orderly. In the event that the value of the collateral drops toward the loan amount, collateral will be sold and the debt automatically covered.

The thing about this optionality, is that someone is underwriting the risk in the event that the value of collateral drops through the loan value before a forced sale can sufficiently cover the liability. The underwriters should understand who they are and what they are doing.

Right now, the MakerDAO Dai Stablecoin is only backed by one collateral asset, ETH. When ETH is put up for collateral, it is first exchanged for a pooled coin called PETH. In the event that a forced sale of collateral cannot cover the Dai in any given CDP, the pooled claim of ETH from remaining CDPs are diluted. This is important. The low leverage CDP contracts are underwriting the risk of the high leverage CDP contracts. If you opened a CDP and borrowed Dai, your liquidation point is somewhere on the following chart, depending on your coverage ratio:

For those with liquidation at the $225 level, they probably feel comfortable that ETH may never reach their liquidation point. I hope they are right. However, if ETH drops through the $500 point and the forced sales are not sufficient to cover the Dai loans, the high leverage CDPs walk away without the liability and it is passed on to the low leverage CDPs in the form of pooled collateral dilution. This is an important point to realize how the product behaves, and understand that there is a possible counter intuitive argument that max leverage has the most value for the individual CDP holder. There is value by maintaining protected downside risk in a bear market, especially when that risk is borne by someone else.

SYSTEMATIC RISK

The forced sales are essentially a negative gamma position. That is to say that the lower the price falls, the more that has to be force sold. In a falling ETH market, it is a mechanism that can make it fall faster and push it down into more and more sell triggers. Right now, there is only $18mm Dai Stablecoin issued.

In Cryptoland, $18mm coin is tiny. But it’s already concerning. Take a look at the above liquidation chart where ETH drops past $500. That is not a ‘sell wall’ to be nibbled at… it is a $5mm ‘sell puke’ that gets triggered when price breaks through $500 and the puke will push it down further through more pukes.

One big Barforama

Sellers need buyers, and the disciplined buyers will wait to bid until the program selling has a chance to breathe.

Daily ETH price swings are typically in the order of 8%–10% as measured by a single standard deviation. Without consideration for logarithmic effects, that daily variance can be generally annualized by multiplying it by 19.1 (square root of 365). Medium term expected price variance (either up or down) is pretty much nonsensical. Forced liquidations with current coverage ratios are not a matter of IF, but a matter of WHEN.

CONCLUSION

CDP positions are essentially a mutated call option in an extremely volatile environment. CDP Stablecoins will actually increase the volatility in the market with leverage and forced sales. High leverage CDP holders are at risk to lose their collateral faster than they might expect, but their risk is limited. Low leverage CDP holders are underwriting more risk than they are likely aware of.

New and exciting derivative products have a habit of extreme growth. I suspect that Cryptoland will not be an exception and the product will gain extraordinary attention this year, both from CDP adapters and also from the regulators. If there is one thing regulators hate, it is misunderstood exposures, especially in the form of leverage.