A Hedge Against Getting Pegged
A Hedge Against Getting Pegged
Manage your risk or risk manages you.
Welcome, Anon! Today we’re diving into a protocol that enables you to speculate on the peg of stable assets and hedge yourself against black swan events.
In a post-LUNA world where people can forget the effects of extreme de-pegging in supposedly stable assets, it is easy to become complacent and assume that stablecoins will always maintain their pegs. Because they are supposed to, right? However, we live in a world where MakerDAO has proposed to make DAI a free-floating currency and Tether went 5% off its peg not too long ago as crypto markets unwinded.
While this provides arbitrage opportunities for people with ice in their veins that could pick up cheap tokens for free, it is not a route everyone is comfortable with especially as you assume the risk of a bank run taking place as fear takes a stronghold of the market dynamics.
What if there was a way to speculate and hedge against de-pegging events? Enter Y2K Finance.
What is Y2K?
Imagine having a product that would have enabled you to obtain insurance against the de-pegging of UST as it went beyond hell. Companies were wiped out and 3AC fled. This is what Y2K enables by allowing you to speculate on the peg of stablecoins (to begin with) through the use of derivatives. While the term stablecoins or stable assets imply that they are stable, people tend to forget that they constantly fluctuate in value depending on the demand.
Why would you use Y2K?
By hedging yourself against volatility in stable assets, you essentially take out insurance against de-pegging limiting your downside. Insurance markets within DeFi have not been solved yet and are among the biggest opportunities if a protocol can get it right. Providing an attractive venue for underwriting risk and speculating on volatility can attract large amounts of liquidity. However, before explaining why that would be the case, we must dive into how the protocol works.
Y2K has three main products that will be available for consumers:
Earthquake
In order to understand Earthquake, we need to have an insight into how ERC-4626 works first. It is a standard for tokenized vaults. ERC-4626 is a standard that solves the conundrum of the composability of yield-bearing tokens in different protocols. Understanding the intricacies of every smart contract related to different tokens that can be deposited in vaults is a pain for developers who want to integrate them into protocols. It also bears a smart contract risk as everyone works differently. With the ERC-4626 standard, this is mitigated by having a unified solution for integrating yield-bearing tokens such as xSushi when you stake Sushi.
Earthquake is the main product of Y2K and uses the ERC-4626 standard for their fully collateralized insurance vaults. Earthquake lets you speculate on the volatility of pegged assets and underwrite their risk. The structured products contain two different risk appetites associated with their vaults:
High Strikes
To keep it short and concise, high strikes refer to the vaults with a strike price (the price level it takes for the stable asset to trigger the vault for liquidation events) close to the peg of the stable asset. These can be as close as $0.998 considering how these types of movements frequently take place in the market as bots and arbitragers quickly jump on the opportunities. High strikes vaults have a 1-week epoch length. As these have high strikes they are expected to have the highest risk as well. If markets are efficient they will provide the highest yield to match that risk. Allowing degens to speculate on stable asset swings.
Low Strikes
Low strikes are what they sound like, they have a strike price further away from the peg and present a lower risk than high strikes. However, this comes with a caveat as the epochs for these months last for 1 month. The low-risk vaults were built based on the Merton Model. The Merton model is a model that measures a corporation’s risk of credit default. However, despite this vault being less likely to play out from a de-pegging standpoint, be aware that being illiquid for 1 month is a big risk in itself. As I’ve iterated multiple times, liquidity is the name of the game in DeFi.
How does Earthquake work?
Premium depositors (insurance buyers) and collateral depositors insurance sellers) speculate on the depeg of stablecoin
ETH gets deposited into vaults depending on what position you take
Speculators receive an ERC-1155 token in return which gives you the right to payout after the epoch depending on how it plays out
Non-depeg events lead to insurance sellers earning a premium for depositing collateral
In case de-pegging takes place ETH gets liquidated and paid out to buyers but sellers still receive the premium earned
When the epoch ends the protocol has a built-in value accrual method for token holders. This includes a 5% claim fee where 30% of that fee goes to people that have locked their Y2K tokens through ve-tokenomics and the remaining 70% is redistributed to the protocol.
I didn’t want to scare you with math formulas so here’s a quick template you can use to play around with the numbers to determine payout calculations.
When you deposit assets into their vaults they are locked during that epoch. However, the ERC-1155 token that you receive in return that gives you the right to claims when the epoch ends can be sold on the secondary market which brings us Wildfire.
Wildfire
Wildfire is a secondary marketplace where the ERC-1155 tokens can be bought and sold. It gives depositors the chance to transfer risk to other parties while people that didn’t buy prior to epoch closing can enter a position in Y2K. Wildfire will use an RFQ (Request for Quote) order book to facilitate this process for users.
Note: If you’re unfamiliar with RFQ, it’s essentially a system that notifies market makers when someone wants to make a large trade that could significantly impact price. To not cause a heavy price impact you make the trade OTC instead. It also allows users to get competitive rates during times of low market activity.
Using wildfire will induce a fee of 0.65% per trade that will be distributed to token holders in the same manner as Earthquake.
Tsunami
There is currently not a lot of information concerning Tsunami yet. What we do know so far is that it’s a CDO (Collateralized Debt Obligation) powered lending market with MEV-proof liquidations. If you’re not familiar with CDO’s it’s basically a pool of loans and other assets that serves as collateral if the loan defaults. This pool normally consists of revenue-generating assets that pay people invested in the CDO. It was made famous during the 2008 financial crisis due to the recycling of risky debt into AAA-rated bonds.
I will update this section when more information has been provided concerning this product.
Pitfalls & Potential Opportunities
For Y2K to be successful, it requires that someone else is willing to take the other side of the trade as liquidity is imperative and has been the main reason why options platforms haven’t taken off. If the ERC-1155 token can be staked or deposited for liquidity providing it will enhance its utility leading to more liquidity. A liquidity pool with the ERC-1155 token on one side and the pegged asset on the other should be attractive if done correctly (setting up a Curve pool for this would be sensible).
Insurance markets are still untapped in DeFi and the protocol that can get it right will unlock a ton of capital in the market. Y2K is taking a step in the right direction for that to happen.
Considering the countless protocols that have or are about to launch their own stablecoin (which I’ve covered in this previous article), using Y2K and depositing collateral would be a way for them to display confidence in their stablecoin. This would allow them to earn a premium on their own assets deposited as collateral. This comes with a risk of course. However, if they can take the ERC-1155 token and stake it to earn an additional yield on top of the premium, they would be heavily incentivized to do so. If the opposite happens and it de-pegs the DAO would be liquidated. In times of high market volatility, it would allow them to hedge themselves as well by buying insurance as well.
Furthermore, considering their attractive value accrual method for their locked token holders (veY2K), it wouldn’t surprise me to see both Redacted and Plutus eye them up through Pirex or PlsAsset to bring in other yield-bearing assets in-house.
What’s Next?
The protocol is currently going through security audits and implementing feedback from their testnet as they are gearing up for launch in late September / early October. Tokenomics outside of value accrual has not been released yet and will play a crucial role in the future success of the protocol.
The speculative nature of true degens will never disappear which is why I’m paying attention to protocols that can foster this behavior while still being a new DeFi primitive. Are you a hedger or a gambler?
Well done if you managed to congest all that information, I hope you enjoyed the post. Don’t forget that you are more than welcome to leave feedback or drop any questions in the comment section.
Sharing this post helps it reach out to more readers which would be great. If you are interested in future posts from me, do not hesitate to subscribe. Thanks for taking the time!
Disclaimer: All Content on this site is information of a general nature and does not address the circumstances of any particular individual or entity. Nothing on the site constitutes professional and/or financial advice, nor does any information on the site constitute a comprehensive or complete statement of the matters discussed or the law relating thereto. I am just a random degenerate sensei sharing an opinion.