Hi all,
Following the proposal to add ARB as a collateral on Vesta, we have been asked by the Vesta core team to validate the robustness of the risk parameters proposed to list ARB as a collateral asset and propose changes if needed. Our assessment takes into account historical and current market data and will have to be reassessed as market conditions change.
In this risk assessment we will provide detailed information about market risk along with recommendations in regards to the following governance parameters: Liquidation Ratio, Debt Ceiling, Liquidation Penalty, Vesta Reference Rate.
Risk Assessment
Market Risks
ARB started trading on March 23rd following the ARB airdrop. The ARB price has been pretty volatile in its first day of trading but has since stabilized in the $1.13 to $1.43 range.
Given ARB has been trading for a short time period, we’ll use OP, Optimism’s governance token as a comparison to better inform our analysis in addition to using ARB’s historical data. Although both assets are unique, OP is likely to be the best asset we can use as a comparison as it is the governance token of Arbitrum’s closest competitor. OP has been trading since June 2022 allowing us to analyze its volatility profile over a longer time period.
Volatility
Let’s analyze the maximum drawdowns, the 1 hour volatility and 24 hour volatility of ARB and OP and benchmark these values against ETH to add more perspective. All of these values are based on Chainlink historical price data.
Asset price volatility - Last week
|
|
1 hour volatility
|
1 day volatility
|
| ARB*
|
1.31%
|
6.47%
|
| OP
|
1.02%
|
4.27%
|
| ETH
|
0.53%
|
1.97%
|
* Excluding March 23rd
Asset price volatility - Last Year
|
|
1 hour volatility
|
1 day volatility
|
| OP
|
1.54%
|
8.48%
|
| ETH
|
0.97%
|
4.30%
|
Maximum drawdowns - Last year
|
|
1 hour maximum drawdown
|
1 day maximum drawdown
|
| ARB*
|
-6.91%
|
-15.49%
|
| OP
|
-17.53%
|
-42.60%
|
| ETH
|
-9.01%
|
-27.14%
|
* Excluding March 23rd
Liquidity
ARB total DEX liquidity has been sitting at over $50M since March 22 2023. ARB liquidity is currently distributed as follow over 136 pools:
- $30M on Uniswap v3
- $7.5M on Camelot
- $3M on Sushi
- $150K on Balancer
See: https://www.warden.finance/tokens/ARB?chain=arbitrum
Given the on-chain liquidity for ARB here’s the expected trade slippage to sell ARB for USDC as of April 4th, 2023:
|
Trade size
|
Slippage (%)
|
| $100K ARB
|
-0.32%
|
| $500K ARB
|
-0.81%
|
| $1M ARB
|
-1.18%
|
| $2M ARB
|
-1.98%
|
| $5M ARB
|
-8.35%
|
Since we can’t accurately know how sticky DEX liquidity will be given the short history, we’ll use OP on Optimism as a benchmark
OP DEX liquidity has risen to similar levels than ARB (~$110M) at inception and stuck at this level for about 30 days, with some momentary drop of about 50%. Total DEX liquidity then dropped about 80%.
As a conservative measure, we can simulate the expected slippage conditional on a decrease of 50% of ARB’s on-chain liquidity over the next 30 days:
|
Trade size
|
Slippage (%)*
|
| $100K ARB
|
-0.64%
|
| $500K ARB
|
-1.60%
|
| $1M ARB
|
-2.36%
|
| $2M ARB
|
-3.96%
|
| $5M ARB
|
-16.70%
|
* Conditional on a 50% decrease in liquidity and assuming the same liquidity distribution profile.
Centralization risks
As part of the Arbitrum airdrop, 12.75% of ARB tokens were distributed to the community.
The largest ARB holder is the Arbitrum treasury and holds more than 35% of tokens in circulation.
As of April 4th 2023, 298 295 addresses held ARB.
On March 27th Lemma Ltd proposed AIP-1, to allocate 750M ARB tokens to the Arbitrum Foundation. This proposal would have allowed the foundation to allocate those 750M ARB as grants or payments without requiring a DAO vote. The proposal was voted against and caused some controversy given that 10M ARB were sold for fiat and 40M ARB were lent to a market marker.
This situation highlights the centralization risks related to ARB. A centralized actor selling a large amount of ARB tokens could greatly alter the volatility and liquidity profile of ARB. As a consequence we recommend limiting the protocol’s exposure to ARB through Vesta’s Mint Cap.
Proposed Parameters
The following risk parameters were voted on and approved by the DAO:
- Minimum collateral ratio: 150%
- VST Mint cap: 0.5M VST
- Liquidation bonus: 15%
- Vesta reference rate: 3.0%
Mint cap
It is our assessment that setting the Mint cap at 500K VST is appropriate and conservative.
Let’s suppose a worst case scenario where one user would mint the whole 500K VST against ARB and be liquidated. Under that scenario, the stability pool depositors would receive ARB in exchange for their VST. Stability pool depositors could then exchange ARB for USDC at less than 1% slippage given the current on-chain liquidity. Even if ARB’s on-chain liquidity decreases by 50% over the coming weeks, slippage to execute a 500K trade would be about 1.6%. Stability pool depositors would then swap USDC to VST in order to profit from the liquidation.
In most cases only part of the 500K would get liquidated as ARB depositors will mint VST at different collateralization levels. Since ARB is already listed on Vesta we can monitor the largest VST debts minted against ARB here: https://vestafinance.xyz/stats/vaults.
500K VST represents about 8% of the current VST supply. If the mint cap is reached due to strong market demand we could reassess ARB’s on-chain liquidity and volatility profile to increase the cap.
Liquidation Penalty
It is our assessment that the proposed Liquidation penalty of 15% is likely to compensate stability pool depositors sufficiently to cover ARB liquidation costs.
A stability pool depositor will incur the following costs when liquidating ARB for VST:
- Slippage selling ARB for USDC and USDC for VST.
- As mentioned previously the slippage cost of selling ARB for VST is sub 1% for a trade size of $500K which implies the whole mint cap would have to be liquidated at once.
- Gas costs
- We estimate the gas liquidation cost at 0% assuming the gas compensation will cover this cost. The only gas cost the liquidator will have to pay is gas to swap ARB for VST.
- Oracle price skew
- Based on historical data, the price skew between the Oracle price and the market price can be as large as 2%. This means that in a worst case situation a liquidator would have lost 2% of the 15% liquidation bonus due to the Oracle price skew.
This means that based on historical data and looking at comparatives assets a stability pool depositor should expect to profit for ARB liquidations assuming the stability pool depositors convert ARB for VST as soon as an account is liquidated. Based on the historical maximum drawdowns of ARB and similar assets the liquidator is expected to have a sufficient buffer to profit from liquidations.
If the stability pool is not sufficiently large for ARB then the VST staking module would execute the liquidation.
We think the proposed liquidation penalty of 15% is adequate for the time being.
Collateral Ratio
The minimum collateral ratio protects the protocol against large decreases in collateral asset prices. We think the proposed parameter of a 150% minimum collateral ratio is appropriate at the current time given ARB and similar asset historical volatility profiles.
The proposed 150% minimum collateral ratio and the 15% liquidation penalty imply that the protocol has an additional 35% buffer. This buffer would protect the protocol in a situation where the ARB price would decrease rapidly before liquidations can occur
To avoid the creation of bad debt, the protocol should set its minimum collateral ratio at a point where it covers for the 15% liquidation penalty and also protects the protocol against a large decrease in the collateral asset price.
Given a 150% collateral ratio and 15% liquidation discount, the buffer left for covering the asset price drawdown until a liquidation is executed is:
(1 / (150% - 15%)) - 1 = -26%
The worst maximum 1 hour drawdown of ARB and other comparable assets in the last year was -17.53%. This is well within the -26% price decline the buffer would have protected the protocol against.
It is our assessment that the proposed parameter of 150% minimum collateral ratio for ARB is likely to protect the protocol against a large decrease in the ARB collateral price even if no liquidation occurs for at least 1 hour.
Vesta Reference Rate
Since we don’t have sufficient information about ARB volatility profile and dex liquidity stickiness and can’t compare with other collateral assets, we think starting with a high baseline preference rate (3% as proposed) is appropriate for the time being and can be reassessed at a later date based on ARB volatility profile and the market demand on Vesta.
Conclusions & Next Steps
Our analysis demonstrates that current parameters are conservative enough to safely bootstrap the ARB market and measure the demand over the following weeks.
As per our measurements, the current mint cap is very conservative. We will reassess it in the following month as we gather more information.
Links to the Warden platform
ARB Token | Warden Finance - https://www.warden.finance/tokens/ARB?chain=arbitrum
OP Token | Warden Finance - https://www.warden.finance/tokens/OP?chain=optimism