Lending Protocol Index (Ticker: LPX) is a perpetual index. LPX will specifically track DAI and USDC yields across the two most popular lending protocols today: Compound and Aave.
Lending and yield farming opportunities have largely driven an explosion in DeFi interest. Lending protocols enable long-term investors to lend out their crypto to earn interest on assets that they would have anyways held. For sake of brevity it is assumed that the reader understands the incentives that lead individuals to lend and borrow digital assets.
One major factor behind this surge in lending protocol demand is that the current fiat interest rate environment; in early 2020 the Fed dropped interest rates to zero, leaving consumers with limited opportunities to earn on their fiat assets. This coincided with a 33% or $2.2B increase in stablecoin volume within a few short weeks as investors sought to keep their money in stablecoin for uses such as lending to earn yield.
Additionally, there new avenues to earn interest were introduced for traditional retail investors via consumer-friendly interfaces such as Dharma and Argent. This surge in demand eventually led to a substantial increase in prices of DeFi protocol tokens with digital assets such as COMP seeing as much as a 4x price increase for its governance token in early July and platforms such as Aave quickly following suit with rapid spikes in price. In addition, yield rates increased for assets such as DAI across distinct networks. However, it has long been thought that Bitcoin prices and yield rates hold an inverse correlation. Meaning that as BTC decreases in price yield rates normally follow an inverse pattern.
Lending protocols are an avenue via which investors can gain exposure to DeFi yield while only investing into a yield basket that tracks DAI and USDC yield across reputable protocols while additionally not being exposed to any form of smart contract risk tor yield volatility hat may be present in any single lending protocol.
The reason for specifically selecting an Index to track DAI and USDC yields is because DAI and USDC currently have two of the largest volumes across different assets currently being lent. In addition, the user will not be beholden to yield volatility on any single protocol. For instance, DAI yield may dip on Compound on a given day but Aave may not have experienced the same form of yield decrease. Purchasers of LPX will also not be exposed to smart contract failure risk to the same degree on the LPX index because if they lend out all assets via one single protocol such as Compound, a smart contract error or hack could lead to assets being lost. Lastly, purchasers of LPX will not need to interact with a lending protocol or lend out their assets in order to earn yield, so LPX can serve as an actual proxy for earning yield without the inherent risks of traditional DeFi lending protocols.
In the future, the idea is to introduce new indices that track yield for other assets as well such as BTC or ETH in order to give investors access to new derivative markets that were not available before.
The LPX basket will track DAI and USDC yield across following lending protocols: Compound and Aave. These lending protocols currently have two of the highest volumes with respect to yield generation for DAI and USDC. In addition, these protocols have been heavily audited relative to other lending protocols in the market today, which minimizes potential risk of smart contract failure that could lead to a rapid loss in yield. This paper makes the assumption that the COMP and LEND token distribution is included in the yield within the following example.
Current DAI Supply Yields
Current USDC Supply Yields
Total Value Locked in Lending Protocols
Total Market Cap: COMP ($1.2B) + LEND ($250M) = $1.450B
Lending Protocol Weighting with respect to Value Locked
COMP: (1.2B/1.450) * 100 = 82.76%
LEND: (250M/1.450) * 100 = 17.24%
Compound Asset Weighting (How much of Compound consists of DAI versus USDC?)
DAI: $1B (83%)
USDC: $200M (17%)
Aave Asset Weighting (How much of Aave consists of DAI versus USDC?)
DAI: $20M (8%)
USDC: $230M (92%)
This index will be priced based on a simple average weighting of DAI and USDC yields across Compound and Aave. The end of this equation divides by 365 in order to derive the rate of yield per day. Additionally, the equation is divided by 288 in order to represent the number of times the price interval is updated (every five minutes means 288 times over the course of 24 hours). Lastly, 1 is added to reflect the fact that this yield is growing the balance of the user (so overall more than 1%).
0.0000003370529 + 1= 1.0.0000003370529 earned daily via yield
Initial Index Price = 1.0000003370529
The reasoning behind this update interval selection is because this index product is composed of a basket of popular high-volume yield markets that often can see a fluctuation in yield price at an interval of a few minutes in some cases. In order to have a standardized interval time and to capture prices for high frequency traders for instance it is crucial to update the price every few minutes. An interval time longer than this will likely miss yield fluctuations that occur over a few minutes.
Recommendation: We would need to retrieve yield rates directly from Compound and Aave. This can be retrieved with a simple API price feed.
Alternative : A decentralized oracle such as ChainLink or Band Protocol can also have a great price feed to retrieve the yield rates. However, these are currently not fully integrated across Compound and Aave, so perhaps this can be done at a later date when the price feeds for yield are available on these oracles.
ChainLink Docs: Link
Band Protocol Docs: Link
There are a number of ways via which investors can hedge their investment into LPX
Options: Investors can use put and call options in order to de-risk an investment into LPX. To protect yourself form falling prices you would buy put options (enabling you to buy LPX at the strike price). Alternatively, if you want to protect yourself from higher prices you would buy call options (enabling you to sell LPX at the strike price). It is important to remember that you need to usually buy the same number of futures contracts and options. For example, if you purchase 5 contacts of LPX you would technically purchase 5 options to hedge against each contract. This cannot get rid of all the risk but can help de-risk the initial investment to a degree.
Bitcoin: It has often been noted by analysts and traders alike that alt-coins and BTC often follow an inverse correlation. The reasoning being that traders sell alts to acquire more BTC which helps increase BTC demand but lowers alt demand. A trader could purchase BTC in order to hedge against the risk of lending protocols and their associated yield rates potentially decreasing in value and usage in the near future. A trader could of course also purchase BTC options (a trader would purchase a BTC call option to hedge against a long position in LPX for instance because the call option would enable them to see some returns in case BTC increases in value while LPX may decrease).
It should be noted that most options come with an expiry date but the futures contract is perpetual so if the option expires then there is an added level of risk to the initial investment into LPX unless the trader purchases another option for example.
Price Volatility: At any time one of the yield rates can decline rapidly due to issues such as smart contract failure on a given lending protocol. For example, if Compound’s DAI yield could fall due to issues such as a hack or a lack of overall demand to lend on Compound. In order to de-risk this LPX should look to add new popular lending protocols onto its basket as they emerge in order to diversify the protocols from which we are retrieving the yield rates. For instance, if the lending markets on a platform such as Nuo grows in demand we can look to add in Nuo. The index divisor can help ensure that there is not a rapid fluctuation in the LPX price if a certain token is replaced in the basket
Liquidity risk: It was stated earlier in this paper that one of the primary factors considered when selecting the four tokens for this basket were the relatively high demand levels for yield on DAI and USDC. This can potentially imply that traders would be interested in the LPX basket but there is no guarantee. There is always a certain level of liquidity risk present when it comes to digital assets
Price Mismatch: Given the two protocols we selected to attain the yield data from it could be possible that the yield that Injective uses in its calculation a token within the basket is different from the current yields advertised publicly. This can occur because likely Injective could miss a yield change within the 5 second interval
Lending Protocols decline in demand: There is a potential for prices of tokens to rise so quickly that some investors may want to trade on more volatile assets rather than just tracking yield on stable assets such as DAI and USDC. This would likely lead to a rapid decrease in the price of LPX if sell pressure is too high. In order to mitigate this risk, the LPX basket can begin to include other asset types that begin to grow in volume (for instance Paxos in the future).