Introduction
On Jun 3, 2024, cupojoseph proposed a pilot stage for funding R&D for the implementation and execution of operating a treasury-backed vault (TBV). He suggests that leveraging a TBV and issuing a stablecoin against ARB (and other treasury assets) in the vault could be a more effective funding mechanism for grants and other initiatives–noting leveraging ARB to issue stablecoins could relieve ARB selling pressure.
After back and forth discourse amongst the community, both in favor and against a DAO-owned TBV, members of the DAO (Entropy and L2Beat) expressed that funding R&D for this proposal is redundant given the ARDC. Hence, Blockworks Research and Chaos Labs were assigned the task of outlining the operational structure and performing a risk analysis of operating a TBV.
Summary
Chaos Labs has performed an analysis of potential ARB CDP Vaults for the DAO to access stablecoin capital without selling ARB. Our findings can be summarized as follows:
- The ARB oracle is healthy and is not an impediment to launching these vaults.
- We recommend an initial liquidation threshold, where a CDP loan becomes liquidatable at 66% of the dollar value of ARB supplied. There should be a 10% liquidation bonus awarded to incentivize liquidators to avoid undercollateralized positions and ensure that the CDP protocol avoids bad debt.
- We recommend an initial loan of 25% of the value of ARB supplied to limit the liability of the DAO to supply more ARB collateral should the value drop.
- Alternatively, the DAO could take a more aggressive approach by taking an initial loan of 44% of the value of ARB supplied. However, this would require implementing more conservative risk management processes to mitigate the risk of loan liquidation at a higher price, compared to a lower initial loan value.
- We recommend an initial debt ceiling of $12m. This means that the DAO could borrow up to $12m safely against a minimum of $48m in ARB collateral at the outset.
- We recommend the DAO establish a ring-fenced safety buffer in ARB to cover any price drops in excess of what is forecast.
Introduction
Chaos Labs presents a thorough risk analysis concerning the establishment of an ARB treasury-backed vault. The primary objective of the original proposal is to enhance the capital efficiency of the Arbitrum DAO treasury while addressing the inherent sell pressure linked to ARB token distribution. Given that a significant portion of the total ARB supply is held with relatively low on-chain liquidity, the token is potentially vulnerable to price manipulation. Therefore, it is critical to set an appropriate debt ceiling when listing ARB to prevent a profitable dump attack. The analysis by Chaos Labs highlights the importance of this precaution to ensure the stability and security of the ARB token within the treasury-backed vault framework.
Volume and Market Cap
When analyzing market cap and trading volumes of assets for listing, we look at data from the past 180 days. The average market cap of ARB over the past 180 days was $2.9B, and the average daily trading volume was $392M (CeFi & DeFi). We find the market cap adequate and the trading volumes reasonable as long as they are considered when setting appropriate debt ceilings.
Historical Volatility
The analysis of ARB (Arbitrum) price volatility over different time frames reveals substantial fluctuations. On a daily basis, the annualized volatility is 84.6%, highlighting significant price movement each day. When extended to a 30-day period, the annualized volatility increases to 93.87%, indicating that the volatility is not only persistent but also more pronounced over a longer duration. Over the past year, the largest one-day price drop was recorded at -17.06%, showing a significant single-day loss. Furthermore, the most severe 7-day aggregate price drop was -33.54%, emphasizing the potential for considerable price declines within a week. These metrics collectively underscore the high-risk nature of ARB, marked by notable short-term and sustained price volatility.
Historical Liquidity
The cumulative depth plot provides a comprehensive visualization of the aggregate liquidity values for ARB on-chain liquidity across a range of price impact spreads, extending up to 10% in both directions—specifically, from ARB to USDC and from USDC to ARB.
The plot prominently features two primary lines, colored red and blue, which represent the average liquidity values computed over the past 60 days under specific price deltas. These lines offer a clear indication of the typical liquidity available within this timeframe, smoothing out short-term fluctuations to give a more stable view of liquidity trends.
Additionally, the plot includes several less prominent lines, which correspond to individual snapshot values of liquidity taken at various points over the same 60-day period. These lines provide detailed insights into the variability and distribution of liquidity over time, highlighting how liquidity levels may fluctuate on a daily basis.
A key observation from this plot is that ARB’s on-chain liquidity is relatively low when compared to its market capitalization. This is an important consideration, particularly in the context of potential liquidation events.
Given the observed liquidity levels and their variance, as well as the potential for induced liquidation events and attempted market manipulation, according to our debt ceiling methodology we recommend setting a debt ceiling value at $12 million. This recommendation aims to balance the current liquidity constraints with the need to maintain system stability during liquidation scenarios.
ARB/USD Oracle
Arbitrum’s efficient and low-latency infrastructure enables the ARB/USD Chainlink oracle to operate with a very tight deviation threshold of just 5 basis points (0.05%). This tight threshold results in the oracle providing over 1,100 updates per day, ensuring the oracle price closely aligns with the current on-chain price, even with minor price fluctuations. This frequent updating is crucial for maintaining accurate price feeds and minimizing the risk of discrepancies.
During this period, the minimum price delta observed between two consecutive price updates was -6.3%. This significant deviation occurred during a rapid price drop, highlighting the potential for large price swings even with frequent updates.
Initial Liquidation Threshold
Given the current volatility metrics, which indicate high levels of uncertainty and price instability, we recommend launching with a Liquidation Threshold (LT) ratio of 66% and aligning with protocols like Aave by implementing a 10% liquidation bonus.
Setting the LT ratio at 66% aims to mitigate the inherent risks associated with the underlying protocol. The chosen ratio takes into account the liquidation bonus, daily price drops, and ARB/USD oracle deviations. It provides a substantial buffer against potential price drops, which is particularly suitable given ARB’s liquidity and volatility characteristics, thereby enhancing the overall stability of the system. Additionally, the 10% liquidation bonus serves as a protective measure, ensuring that liquidations are adequately incentivized and executed efficiently, further safeguarding the protocol against extreme market conditions.
Initial Loan Health Ratio
The Initial Loan Health Ratio is the recommended LTV ratio of the collateralized ARB relative to the debt employed, based on the parameters we derived. This measure assesses the stability and risk associated with a loan at the time it is issued. By ensuring a strong Initial Loan Health Ratio at initialization, we can better protect the system against potential price drops. This is important to protect the DAO against needing to continually supply more ARB to keep the borrow position healthy.
In this treasury-backed vault, we no longer use probabilistic models for liquidation events based on an aggregation of positions. Instead, we assume the entire position is concentrated within a single user. This change simplifies the modeling process and focuses on a worst-case scenario approach.
Assuming frequent system monitoring, we recommend starting with an initial health state that correlates historical daily price drops with the capital efficiency employed at system initialization. This method ensures that the system’s health is robust from the onset, taking into account significant past price movements to set a conservative baseline.
Based on this assumption, we recommend the following:
- Initial Health State: Set an initial health state resilient to historical daily price drops. Analyze past price data to determine the worst-case daily declines and ensure the system can withstand these drops without triggering liquidations.
- Capital Efficiency: Balance capital efficiency at initialization with the need to maintain a high level of system health. While the system aims to be capital efficient, it must not do so at the expense of stability during significant price drops.
- Monitoring and Adjustments: Implement frequent monitoring to respond quickly to any changes in market conditions. This allows for timely adjustments to the health state and other parameters, maintaining system stability.
Conservative Recommendation: Worst Monthly Price Drop
- Price Drop: -61.75%
- Liquidation Threshold (LT): 66%
- Initial LTV: ≤ 25.24%
For a worst-case monthly price drop of 61.75%, the initial LTV ratio should not exceed 25.24%. This conservative recommendation is designed to offer maximum protection by setting the LTV at 25.24% or lower, ensuring the position remains secure even during extreme market fluctuations.
Aggressive Recommendation: Worst Weekly Price Drop
- Price Drop: -33.54%
- Liquidation Threshold (LT): 66%
- Initial LTV: ≤ 43.64%
Utilizing the worst-case weekly price drop of 33.54%, the initial LTV ratio should not exceed 43.64%. This more aggressive recommendation allows the treasury to leverage its position up to 43.64%, providing a higher potential return while still safeguarding against severe weekly market downturns.
Safety Buffer in ARB:
It is impossible to guarantee that any debt position will not require additional capital to remain healthy. For this it is recommended to ring-fence a safety buffer in case the value of ARB drops more than previous fluctuations predict. The size of the safety buffer should be set as a function of the health factor of the loan taken.
Under the assumption that these recommendations are utilized, the treasury must adapt to price movements by instituting a safety buffer in ARB. This buffer allows the treasury to periodically top up the position, thereby avoiding liquidation. If the treasury reacts to top-ups at different rates, it must carefully manage these adjustments to ensure consistent protection against volatility.
Taking the more aggressive recommendation, with an initial LTV ≤ 43.64%, comes with the necessity of more frequent monitoring and adjustments. This higher level of vigilance is required to promptly respond to market changes and top up the position as needed, thereby maintaining stability and minimizing the risk of liquidation. Conversely, following the conservative recommendation, with an initial LTV ≤ 25.24%, requires less frequent monitoring. This approach provides a larger buffer against price drops, reducing the need for frequent interventions and enhancing overall system stability.
Interest Rate Implications:
Setting interest rates at or above market levels is essential for adequately compensating for intra-protocol risk, particularly when dealing with highly volatile collateral assets like ARB. If interest rates are set too low, the CDP protocol faces multiple challenges, including insufficient compensation for the risks taken, increased sell pressure on the stablecoin, and potential bad debt accrual due to the instability of the collateral.
Exotic collateral assets like ARB necessitate higher interest rates to account for their elevated risk. Without these higher rates, the protocol may fail to attract sufficient revenue and liquidity, exposing itself to instability. Ensuring that quantified risk parameters align with the protocol’s best interests and sustainability is crucial. This involves maintaining the stability of the underlying peg and enhancing the efficiency of liquidation mechanisms to swiftly address under-collateralization scenarios.
By carefully calibrating interest rates and risk parameters, the protocol can:
- Adequately Compensate for Risk: Higher rates reflect the increased risk associated with volatile assets like ARB, ensuring sufficient compensation.
- Prevent Sell Pressure: Appropriately set interest rates can help mitigate sell pressure on the stablecoin, as it frees up additional capital to be utilized to incentivize value maintenance and stability.
- Avoid Bad Debt: Higher rates help manage potential bad debt accrual, given by the increased revenue injection, reducing the likelihood of instability.
Below we present a table with the average stablecoin borrow APY on Aave V2 and V3 associated with respective timeframes.
| Timeframe | Average Borrow APY |
|---|---|
| Last 1.5 Years | 7.51% |
| Last 1 Year | 8.68% |
| Last 6 Months | 10.04% |
| Last 3 Months | 8.85% |
Given that approximately 95% of the current $2.5 billion in collateralized stablecoin debt is secured against safe, blue-chip collateral assets such as WETH, WBTC, and wstETH, as illustrated below, the borrowing rate for using pure ARB collateral needs to be carefully adjusted to account for ARB’s inherent volatility.
This adjustment is essential to ensure that the treasury can adequately compensate the counterparty for the increased risk associated with using more volatile ARB collateral. Unlike blue-chip assets, ARB can experience significant price fluctuations, as seen over the last few months, which increases the risk of collateral liquidation and poses a challenge to the stability of the debt position.
Furthermore, the borrowing rate must also consider the persistent flow of dumping the stablecoin, which can exert downward pressure on its value and create additional instability within the protocol. By scaling the borrowing rate to reflect both the volatility of ARB and the dynamics of stablecoin dumping, the underlying protocol can maintain a balanced and stable environment. Additionally, it can potentially allocate generated revenues to incentivize peg stability mechanisms, enhancing the overall stability and robustness of the system.
The pure interest component paid by the DAO is contingent on the specific derivation method used by the protocols, which could be a fixed derived rate or a utilization rate function, depending on the implementation. This would likely involve a collaborative effort within a prospective CDP stablecoin or lending protocol.
Disclaimer
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