TLDR - Frax should partner with DYDX to enable minting of FRAX using delta neutral hedged positions
Before there was DeFi, the most prolific “dollar” creation in crypto took place on derivatives exchanges. By holding spot collateral and shorting the futures or swaps, a trader effectively fixes their crypto asset at a dollar denominated value. The dollar value created was the result of a delta neutral position, one where longs are hedged with shorts exactly. While “dollars” were created as debt, no withdrawal methods existed to mint this dollar as tokens and they remained solely in CEX accounting ledgers.
What is a delta neutral position?
“Delta neutral is a portfolio strategy utilizing multiple positions with balancing positive and negative deltas so that the overall delta of the assets in question totals zero. A delta-neutral portfolio evens out the response to market movements for a certain range to bring the net change of the position to zero.”
With a delta neutral position, you have no price volatility. You don’t make or lose money from price changes.
For example, you own 1 BTC. To open a delta neutral position, you short 1 BTC with a perpetual swap. The position now has +1 BTC spot and -1 BTC short swaps = 0 delta. Any price changes in BTC would have no effect on your PNL.
Additionally, there is a funding rate which is paid every 8 hours. When its positive longs pay shorts. When it’s negative, shorts pay longs. Typically for BTC and ETH funding rates are almost always positive.
So what about DeFi?
The problem with opening delta neutral positions in DeFi was that there was no decentralized, trustless method of enabling swaps and futures… until now.
With the launch of DYDX, derivatives trading is now available for all (sans USA). This opens up the possibility of a brand new collateral type for FRAX minted through a new type of AMO.
Hedge AMO - Delta Neutral assets as FRAX collateral
We should partner with DYDX to create Hedge AMO, a system that takes in ETH and BTC and opens delta neutral positions on their platform. When assets + FXS are deposited into the AMO, FRAX is returned at a fixed rate based on the dollar value of the delta neutral position. These positions stay open so long as they are being used as collateral for FRAX.
In theory we could issue FRAX at 100% the value of the collateral. The position is hedged and its value is guaranteed.
For example, a FRAXamilist deposits 2 ETH worth $8600 + $1400 usd FXS into the AMO. They recieve back $10,000 FRAX. The collateral now becomes owned by the protocol.
How we profit
The delta-neutral position generates/pays interest depending on the market condition. This is possible because of the funding rate. Longs pay shorts when the funding rate is positive and shorts pay longs when negative.
When the funding rate is positive, the interest will be distributed to UXD holders and the insurance fund. When the funding rate is negative, the insurance fund will pay out the negative rate so that UXD holders do not have to pay any interest.
Hedge AMO would receive the funding every 8 hours and periodically withdraw and purchase FXS for veFXS holders. If the funding rate is negative, the protocol will use funds from an insurance fund.
While some months old the funding rates for DYDX have averaged 40% annualized, with higher rates attained at times.
You can see in the link below that funding is default positive (coded as part of DYDX core logic) and that negative funding rarely persists for a long stretch of time.
Hedge AMO would be a game changer for FRAX. It would allow for the protocol to take in non-stablecoin as collateral for the first time. This could open up great possibilities for growth of network owned protocol and add an extra income stream. Additionally we would partner with one of the best teams in DeFi, setting ourselves apart further from the competition.
There are a few technical things to worry about
- Should the swap rate be 1:1 or at a premium (5% / 95% LTV?)
- What is the slippage/fees for opening the position?
- Negative convexity of large position sizes
- How to unwind large position sizes?
- How to trustlessly enable programmatic trading on DYDX by AMO?