The Hidden Risks of Volatile Assets and the Case for Pegged Asset | Teddy Woodward - Notional

here today but you're in for a treat we got a Minnesota Vikings fan over here Teddy Woodward is the co-founder of national and he's going to be talking about rethinking oo sorry I want to make sure I'm right about this yes rethinking defi lending the hidden risks of volatile assets and the case for pegged asset lending big round of applause please for Mr Woodward hey guys uh I'm Teddy Woodward I'm the co-founder of notional uh notional is a lending protocol on ethereum that specializes in fixed rates and leverage yield strategies okay so today I'm wait a minute it's not on it's not on the screen okay all right today I'm going to talk about two kinds of lending uh volatile asset lending and pegged asset lending so volatile asset lending is something I think we're all familiar with um it is kind of the OG in defi lending uh a a borrower puts down a volatile asset like Bitcoin or eth as collateral and then borrows a uncorrelated asset like usdc against that so volatile asset lending has a really strong track record it's been around since the beginning and because of that uh defi investors tend to think that it's safe and and low risk Peg Des at lending is is a little bit newer and um this is when the borrower puts down a yield bearing asset such as staked eth and borrows a base token uh like eth that's pegged against the collateral asset um investors tend to think this is a little riskier because it is newer and because the lateral types are are more complex and exotic um but I think that is incorrect and it's not the case that this is riskier than vle asset lending uh the risks are just distinct and different so I'm going to make a few claims first is that volatile asset lending is riskier than you think it is despite its track record uh the second is that pegged asset lending uh is not riskier than volatile asset lending it just has different risks and that lenders should diversify and do both okay so let's dive into volatile asset lending so in this kind of lending you're primarily focused on Market risk so what you're worried about here is that the value of the borrower collateral decreases really fast and then all of a sudden uh the borrower's debt is worth more than their collateral and they're insolvent and the protocol has bad debt and the way we mitigate this is liquidation so this is something that I'm pretty sure everyone is familiar with um but we can give a quick overview so the way this works is that the collateral value declines and the borrower becomes underc collateralized at that point the Liquidator can buy that collateral at a discount sell it on the market um for the borrowed currency take that borrowed currency repay the debt and keep anything left over as profit now the issue with this uh is something we call the window of opportunity so in order to liquidate successfully you have to liquidate after the price has fallen such that the borrower becomes under collateralized but before the price Falls so much that the borrower becomes insolvent so in order basically to mitigate the risk for the lending protocol you have to liquidate within this window and this window can be quite narrow in terms of price and time um you know on a bad day the market can sort of blow through this in in the course of a few hours so really the risk in volatile asset lending is the time constraint that this window of opportunity uh presents um and the risk you're you're worried about is is that for some reason liquidations fail during this window when they have to happen and uh if that happens then the protocol is at risk of bad debt so we're going to go through some reasons why that might happen um but before that uh let's just dig into a little bit of the the sort of Liquidator economics here because this is important to understand why liquidations might fail um so basically liquidations are premised on the Liquidator making money and if you want liquidations to happen it needs to be profitable and if they're not profitable then they very well might not happen so again here uh uh the Liquidator buys the collateral at the Oracle price minus a discount and then sells the collateral at the market price minus slippage so their profit margin is the difference between the price they sell it on the market and the price they buy it from the protocol and their total profit is then the amount they liquidate times the profit margin minus an upfront gas cost so there's three primary factors that like can impact the profitability of liquidations the first is high gas prices so gas prices on ethereum are very correlated to periods of Market turbulence and price crashes which is to say that exactly at the times you need to liquidate uh are the times you're going to be be paying the highest gas prices so this data comes from earlier this month when eth went down by like 20% in a day and at this time gas fees spiked up to you know about 300 Gay so this means that liquidations are very expensive to do and when notional was liquidating through this period liquidations were costing like $400 or $500 each and so what that means is like the Liquidator has a very high hurdle rate that they have to make enough money on the discount to cover The Upfront cost which is significant all right the second thing um that is probably less wellknown is is something I call Price Divergence um so the issue here is that the liquidation price that the Liquidator pays is calculated off of the Oracle price whereas their sale price uh is calculated off of the market price and those two prices are not the same so during Stable Market conditions they're they track each other pretty closely but during like turbulent market conditions when prices are moving around a lot and you know gas prices are high and the chain is really congested they can actually diverge quite a lot um and that's because like people are putting trades through dexes and you know the market prices are moving around a lot and the Oracle prices are like having trouble getting their updates into the chain and and so you know uh there can just be a big disconnect um so this chart here kind of demonstrates that um this is easy eth eth uh uh uniswap price data from the easy eth dpeg last April so the blue parts of the line which are very very small um are are points in time when the market price and the Oracle price were within 1 and a half% of each other but the red part of the line which is basically the entire line is when that Divergence was greater than 1 and a half% so that's like most of the time if not almost all the time um and the reason that matters is like you know you can imagine that if this Divergence is 5% and the liquidation discount is 4% then the Liquidator uh may end up paying a higher price uh even including the discount when they buy the collateral uh then then they're able to sell on the market and so liquidations just won't happen because they're not profitable okay uh the third and and maybe most important thing is liquidity so the liquidity of many uh really popular collateral Assets in defi is actually really thin on chain so as an example we've got rapti eth here in a with about $4 billion um and their total Dex liquidity across all chains is only 75 million and so that's a really big problem because you have to if you have to liquidate like a big chunk like say you had to liquidate $200 million uh you would basically be totally unable to do that within a period of a few hours and you know once again this is where the time constraint imposed by the window of opportunity comes into play because if you had a week to liquidate it it would be totally fine um but because you might only have a few hours um you know like uh uh this is there's a real risk that you aren't able to do that and the protocol then faces solvency okay so to sum up here uh um basically high gas prices price Divergence and low liquidity of collateral assets can lead to unprofitable liquidations and potential liquidation failures during the window of opportunity which can lead to uh a potential like bad debt occurring to the protocol um so you know these risks aren't necessarily huge but they are there and they can never be fully mitigated so lenders if you're doing if you're lending against sort of uh volatile assets you need to be aware that you're taking some real risk um that will never go away all right so let's move into Peg DEET lending so to reiterate this is the act of lending a base token like ether usdc against assets that are pegged to that that token like for example R Stak eth easy eth pts uh RS e eth LP tokens and to be specific when we're talking about pegged assets we're talking about redeemability so uh specifically um an asset is pegged if there is a Redemption path by which you can convert that asset into the base token without trading on the market right so like for the example of stake d it's the simplest example you just unstake it and you get eth back and you never need to sell your staked eth so you never need to actually interact with the market price and the same thing exists for all these examples here okay now this is the key characteristic of pegs at lending because you're able to redeem without ever touching the market you can be completely insulated from Market volatility because you know that once you initiate the Redemption you know exactly how much you're going to get at the end of the Redemption process and so that means that any sort of Market volatility in between just doesn't matter right because if you have some stake eth and you unstake it and you get eth back it doesn't matter what the price of Stak eth is on the market and that's really great because it means you don't have to worry about uh you know the price of stake de tanking all you have to care about is the Integrity of the Redemption mechanism okay and to fully take advantage of uh what makes pegdaa lending special you kind of need to rethink the way you do liquidation so traditional liquidations because they involve the Liquidator trading on the market there is a sort of market price dependency uh but the way to sort of fully take advantage of this uh attribute of pdet lending is to do forced Redemption instead so in this what this is is is that uh once the borrower becomes under collateralized instead of liquidating the protocol initiates a forest Redemption so it takes the borrower's collateral and essentially pushes it into the Redemption path that will ultimately end up getting the base token back to repay the debt and it never has to trade on the market and that's that's the important thing so the pro of this is that you uh you're completely insulated from Market risk but the con is that it's more complicated because you have to like uh put the handling of the entire Redemption path in the protocol itself um so the protocol has to be able to like handle each step along this path to getting the base asset back so an example of what this would look like oh and I'm running out of time here um is the uh uh so for one month RSC pts you initiate the force redeem you wait for the PT to expire take the RS eth submit the withdrawal request finalize the withdrawal collect the eth and repay the eth debt so it's a multi-step process so in order for this to work you have to like there's a lot of handling that has to be done on the protocol side but again the upside is that you're completely uh it allows you to completely circumvent Market risk okay so the risk for pegged asset lending it's not risk-free even if you can take away the market risk is the Redemption risk so each asset uh has a different um uh set of things that can happen that would haircut the Redemption value of that asset um so for example RS e uh you know it's slashing sde maybe you're worried about negative funding risk STI you're worried about the PSM draining um so it's different for each asset and so is the mitigation you need to understand all the different things that could happen think about what the worst case scenario is and set your risk parameters such that even in that worst case scenario you can reasonably expect uh the protocol to not see insolvency okay all so to sum everything up here um volatile asset lending has a long track record it's done really well but there is this Market risk component that is never going to go away pegged asset lending is newer um and it has a qualitatively different kind of risk uh now investors tend to think of risk as a one-dimensional spectrum and they want to you know there's less risk on the leftand side most risk on the right hand side and they kind of want to be all the way on the left-and side um but that is fundamentally I think the wrong way to think about it you cut my bik anyway thank you everybody [Applause] the mo while droes over slow motion d