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ETH Exposure Through Leveraging DAI

There were two contrasting pieces of news about cryptocurrency regulation in India this past week. In one, a standard filler FUD piece by NDTV, there was the following.

Effectively, the article conveys nothing new. Nothing other than cash is (or has been) legal tender, not real estate, not even gold. Banning, controlling and regulating are three very different things. Also, if the Government wants to launch its own CBDC (crypto-backed digital Rupee), it cannot at the same time also ban cryptocurrencies. It might, as Iran is currently doing, put in a regime for tracking and tracing cryptocurrency ownership. As we have always said, regulatory clarity will be welcomed not just in India, but by the global crypto community looking at the India opportunity. You can price risk, but you cannot price uncertainty.

Another piece in Quartz by Nupur Anand was far more balanced, and spoke about a leading law firm advising a governmental panel set up to probe cryptocurrencies, advising the panel to take a constructive, progressive view on cryptocurrencies. We think this is probably far closer to reality. A common view in various crypto forums is that there is going to be regulatory clarity in the next few months, after the national elections that are due in Q2.

Also, If you want to read another obituary on bitcoin, this is a nice puff piece.

By the way, the piece we wrote on FactorDaily on crypto and geopolitics was timely and continues to drive debate, aided also by the fact that in the interim, multiple governments have been making progress on crypto-versions of their fiat currencies. Iran’s crypto rial is making progress, the UAE and Saudi Arabia are planning one, and going above the news article above, India is also apparently planning one!

Using the DAI stablecoin to gain leveraged ETH exposure

TLDR; Today’s core post is a detailed exploration of how one might use the DAI, a decentralized, crypto-collateralized stablecoin, to gain leverage exposure to ETH. It is an interesting post in that it portends the type of financial instruments that will characterize the emerging DeFi (distributed finance) era over the next few years. We are using a completely decentralized cryptocurrency, that is theoretically pegged to the US Dollar, to gain exposure to Ethereum, another decentralized cryptocurrency. In a few years, such structures will likely be commonplace across desks at most investment banks. To coincide with the launch of Fordex, the world’s first stablecoin DEX with a fiat on-ramp, we will be periodically looking at analyzing investing and trading strategies that are actionable, for those that are so inclined.

Most of the trading activity that we are witnessing in stablecoins currently is as a result of speculators chasing ephemeral arbitrage opportunities that stem from price discrepancies of various stablecoins, against the base currency, such as the US Dollar, and amongst themselves.

To see how arbitrage works in stablecoins, let’s see how fiat-collateralized stablecoins work. In fiat-collateralized stablecoins, every stablecoin that is issued (or minted, technically speaking) is backed by a dollar that is deposited in a bank account. The price stability of stablecoins stems from the fact that each token can be redeemed for a dollar minus any service fees. So, in theory, every stablecoin should be priced at a very slight discount to a dollar. However, the ebb and flow of markets creates arbitrage opportunities for traders through price discrepancies where stablecoins trade at a premium or a discount to their ideal price of $1 per token.Consider two cases where the price of a stablecoin is above $1 in case and below $1 in another. For the purposes of illustration, we shall refer to two popular stablecoins, USDC and PAX. Note that this is a pair that is available to trade on Fordex.

Case 1 (price of a stablecoin is above $1, say $1.02):

1.Send $1 to USDC/PAX to get 1 USDC/PAX token in return
2.Sell the USDC/PAX token on the exchange for $1.02 and make a risk-free profit of $0.02

Case 2 (price of a stablecoin is below $1, say $0.98):

1.Buy 1 USDC/PAX token on the exchange for $0.98
2.Send 1 USDC/PAX token to USDC/PAX and get $1 in return, effectively making a profit of $0.02

The possibility of a zero-risk profit due to price discrepancies is driving up the issuance of fiat-collateralized stablecoins in general.In the case of crypto-collateralized stablecoins such as DAI, where the stablecoins are overcollateralized with ETH, arbitrage trading becomes much harder. For every $1 in ETH as collateral, only $0.66 worth DAI tokens are issued. In order to profitably arbitrage DAI, the price of the DAI token should be above $1.5 (which is unlikely). That said, crypto-collateralized stablecoins such as DAI have a nuanced feature that allows users to gain leveraged exposure to the underlying collateral. Let’s take a  step-by-step look at how that can be achieved with a $100 investment.

1.Buy $100 worth of Ether on any exchange and transfer it to a CDP to get DAI tokens
2.Assuming a minimum collateralization ratio of 150% (CDPs with <150% collateralization are liquidated to cover the DAI outstanding), the CDP will issue 66.67 tokens of DAI (100/150). At this point, the user owns the underlying $100 in ETH and also has access to 66.67 DAI tokens that the CDP minted
3.Using the DAI tokens, roughly $66.67 worth of Ether can be purchased on an exchange
4.The new Ether that is purchased can be used to create a new CDP with 150% collateralization ratio again. The new DAI tokens issued by the CDP with $66.67 worth of Ether as collateral would be 44.44 (66.67/150%). So, the total exposure to Ether a user has after opening a second CDP would be worth $166.67 ($100 from the first CDP and $66.67 from the second one)
5.This process can be repeated ad infinitum until theoretically the DAI issued drops to close to zero

The theoretical limit for the maximum leverage that you can get is the summation of an infinite GP series with (1/r) as the multiplying factor, where r is the minimum collateralization ratio (r = 150% in this case).

L = 1 + 1/r + 1/r^2 + 1/r^3 + 1/r^4 + ………..

Solving the infinite geometric progression leads to a maximum theoretical value of L = 3, or 3x leverage is the maximum one can get after a large number of iterations.

The table below shows the amount of leverage to Ether that a user gets after ‘n’ rounds of CDP creation.

Amount of leverage to Ether that a user gets after ‘n’ rounds of CDP creation

With cryptocurrency adoption still in early stages, we do not have the same wide-ranging options of complex investment products (leveraged trading, shorting, etc.) that we have in traditional asset classes. However, DAI’s crypto-collateralization mechanism allows users to gain leveraged exposure to the underlying collateral (currently ETH) in almost a transparent and trustless manner through creation of multiple CDPs.

It is widely recommended that users  create a meaningful buffer by keeping the collateralization ratio in excess of 150% to prevent CDP liquidation in the case of ETH price declines. DAI has a minimum collateralization of 150% and if the dollar value of collateral ETH drops below 150% of the DAI outstanding, the CDP is liquidated to cover the outstanding DAI. For example, having a collateralization ratio of 200% provides users with a safety net against CDP liquidation if the prices drop by 25% or less.

How to Gain 1.5x Leverage to ETH with a $100 Investment (Assume 1 ETH = $100):

Step 1: Buy ETH worth $100 on any exchange (ForDeX has a fiat on-ramp to buy ETH for $)

Step 2: Create a CDP on DAI’s platform using the $100 worth ETH as collateral with a collateralization ratio of 200%. Overcollateralization, in excess of 150%, provides buffer against ETH price decline of 25% or less. The CDP issues 50 DAI tokens in return

Step 3: Use the 50 DAI tokens to buy more ETH on any exchange (ForDeX can be used to buy ETH for DAI tokens). Now you have $50 worth ETH again

Step 4: Repeat Step 2 but this time with $50 worth ETH as collateral and a collateralization ratio of 200%. Now we have $150 worth ETH locked up as collateral and $25 worth DAI tokens (from the second CDP in Step 4).

Leveraged Exposure Outcomes:

1.If ETH goes up by 10% (price increases to $110), the combined collateral in both CDPs is now worth $165. $15 worth ETH can be released from the CDPs to bring back the collateralization ratio to 200%. Essentially, a 15% profit is made on an initial investment of $100, which is higher than the 10% price increase of ETH
2.If ETH goes down by 10% (price decreases to $90), the combined collateral in both CDPs is now worth $135. In this case the collateralization fell from the initial ratio of 200% and $15 worth ETH needs to transferred to the CDPs to restore the 200% collateralization ratio. However, because we started off with a collateralization ratio of 200%, which is higher than DAI’s minimum of 150%, the CDPs are safe from liquidation until the price of ETH drops by less than 25%.   

Meanwhile in Crypto Wonderland….

“Boerse Stuttgart Group Launches Bison”Germany’s second largest stock exchange, Boerse Stuttgart Group, has officially launched its crypto-trading app Bison. The aim of the app is to ease access to cryptocurrencies for investors that are accustomed to using traditional markets. Another subsidiary of the stock exchange, Blocknox, will act as custodian for users’ funds, using an escrow system, according to a press release published on Finextra today. Boerse Stuttgart has also partnered with an external banking partner, SolarisBank, which will process euro payments and provide fiat custodial services.

“Binance Enables Credit Card Payments” Binance, the world’s largest crypto exchange, has enabled credit card payments on its platform to allow users to purchase Bitcoin and other major crypto assets using Visa and Mastercard. The integration of credit card payments into the Binance trading platform comes after Binance CEO Changpeng Zhao (CZ) earlier emphasized the importance of fiat on-ramps in increasing the mainstream adoption of cryptocurrencies.

“Panda Group Launches PoS Terminal” The Colombian-based Panda Group has announced the launch of a cryptocurrency point of sale (PoS) terminal called Xeler that also acts as a portable digital currency automated teller machine (ATM). The hybrid solution installed in Bogotá, allows customers to not only buy goods with cryptocurrencies but can also dispense BCH, BTC, and DAI in exchange for Colombian pesos

.“Blockchain Capital Leads Round in TRM”US-based investment firm Blockchain Capital has led a seed round for  blockchain compliance startup totalling $1.7 million. Tapas Capital, Green D Ventures, The MBA Fund, and “strategic angel investors” also participated in the round. The company is going to spend the funds on scaling its engineering talent and expanding the capabilities of its platform. TRM has developed a so-called token relationship management platform to help crypto businesses streamline their Anti-Money Laundering compliance. The platform reportedly offers due diligence solutions, transaction monitoring and customer relationship management.

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