Hedge AMO - Delta neutral assets as FRAX collateral

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.

Supporting Data

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.

Conclusion

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?
6 Likes

This is a fantastic idea! I would fully support this. As some of you probably know (as I’m sure @ssmccul knows since he is an OG), the Hedge AMO was one of the first proposed AMOs when we launched FRAX v2 back in March. I think we should set up a community core AMO group in charge of developing and designing this as well as talking to DyDx (or Perp Protocol) for making this AMO possible. We can create a grant/funding for this AMO Working Group. We would need a few guys including a developer to push the code to be merged as it is ready. What do you guys think?

1 Like

This is indeed a gamechanger.
We need to move fast on this one.

maybe we could put up a bounty to fund this?

like we did here >

https://snapshot.org/#/frax.eth/proposal/QmWjDygUgNcmUreJH2QjjfQyp8Jsf1DLFT1uQCu1iSWg7Q

We will support it if Sam think it is good idea. But not sure what kind of risk could bring to FRAX’s AMO( on dydx) if lost greater then colleterial in DyDx. And that won’t happen to other frax’ AMOs. DydX’s delta neutral hedged is the same as https://lyra.finance/ But Lyra rewards its stablecoin stakers with very high % of its token. Have to make sure FRAX is not played by DyDx

not sure what you mean about the losses being to great.

the way i see it the proposal is just to use DYDX as a place to hold a net neutral position.

so if someone deposits $1k in ETH that ETH is then put in 1x short position, if the price of ETH goes up the position loses in ETH value, but the remaining ETH is still worth $1k. if the price drops the position gains ETH and this holds the value of the asset at $1k even tho the price is going down.

this reduces the swings in asset value to almost 1-2% ( slippage and fees) which is much smaller then the swings ETH has normally.

doing this will make ETH a stable asset that can be used as collateral.

The Hedge AMO is a very good idea, have been thinking about it as well.
Issues I see:

  • DYDX and Perpetual only accept USDC as collateral. This means we need to put up USDC collateral to short ETH and balance the collateral to avoid liquidation. Being able to use ETH as collateral would help.
  • Trustlessness of trading on DYDX. Is it possible to own and trade on a dydx account as a contract?
    Perp v2 is on Arbitrum and is done via a smartcontracts, so I think we can handle deposits/redeems including adjusting the short position on Perpetual in the same call offering depositors the current price on the Perp market.

Hey, Nick from the Perp team here. There’s definitely some interesting points and we see some very long term synergies that could be had.

We are working on multiple collateral types which might be interesting in two forms:

  1. Ability to hedge and be delta neutral as per above
  2. Ability to use FRAX as a stable asset

Perp is fully decentralised and so anyone can actually integrate with the smart contracts! To make things as smooth as possible we have a couple of mechanisms that can help out as well:

  • Grants: we have a grants program that will help fund any integrations into Perp
  • Integrations team: if anyone wants to reach out please do, we have an integrations team that is very responsive in helping all our partners build on top
2 Likes

So, you can’t see the risk, I have to disagree this proposal

from what i can tell you think there is a risk of losses from trading in a short. but this is not the case, it will be net neutral , so the $ value of the trade will remain the same.

the only losses are the fees to open and close the trade, but these should be covered due to the funding rebate if the trade is open for some time.

also >> Snapshot