DAI/USDC interest rate spread

This document goes over the specific risk and return drivers of the fDAI/fUSDC interest rate spread strategy.

Motivation

The fDAI/fUSDC spread vault allows users to enter a strategy where they borrow one stablecoin at a fixed rate in a given maturity, swap it for another stablecoin, and lend that other stablecoin at a fixed rate in the same maturity in order to profit from differences in Notional rates.

For example, consider a vault that borrows USDC in the 6 month maturity, swaps the proceeds on a DEX for DAI, and lends the swapped DAI at a fixed rate in the 6 month maturity on Notional. The vault allows users to profit from the interest spread between USDC and DAI with a high degree of leverage with the added benefit of keeping Notional stablecoin interest rates more in line.

Return drivers

The return of the fUSDC/fDAI strategy has two main drivers:

  • The DAI/USDC interest rate spread

  • The DAI/USDC cross currency exchange rate

For example, consider a vault that borrows USDC in the 6 month maturity, swaps the proceeds on a DEX for DAI, and lends the swapped DAI in the 6 month maturity at a fixed rate on Notional. A user could deposit $100,000 of USDC, borrow $700,000 USDC on Notional at a net 3% interest rate for 6 months (incl. slippage and vault fees), swap the 800,000 USDC for 800,000 DAI, and lend the DAI at a net interest rate of 6% for 6 months (incl. slippage). Assuming the DAI/USDC exchange rate is stable, and the position is held to maturity, the user would generate $24,000 in DAI interest and pay $10,500 in USDC interest generating a net return of $13,500 over 6 months or 27% annualized.

The profitability of this strategy can be summarized with the following formula if held to maturity:

Risk factors

Price risks

Exchange rate risk

The strategy is subject to some exchange rate risk as the DAI/USDC peg could potentially break. For example, consider a user that borrows USDC and lends DAI. If DAI depreciates in value against USDC, the vault's leverage ratio would increase.

If a user's leverage ratio is ever higher than the vault's maximum leverage ratio, the account would become eligible for liquidation. An account leverage ratio can be calculated at all times using the following formula:

Where debt is considered at face value. For example, if a user borrows 100 fUSDC worth 95 USDC, the user's debt will be valued at 100 USDC in the leverage ratio calculation.

For example, consider the following account:

  • fDAI balance: 100,000

  • fDAI PV: 0.98

  • DAI / USDC exchange rate: 1.00

  • fUSDC balance: -90,000 (debt)

  • Maximum leverage ratio: 0.05 (21 X leverage)

  • Vault shares balance: 100,000

The value of a vault share at any point in time can be calculated using the following formula:

Let's now recalculate the account leverage ratio assuming the DAI / USDC exchange rate decreases to 0.95:

The ending leverage ratio has now breached the maximum leverage ratio. The account is therefore eligible for liquidation.

Interest rate risk

Interest rate risk can also affect the strategy's leverage ratio if the interest rate spread widens over time.

For example, consider an account that borrows USDC for 6 months at 2% and lends DAI at 4%. If the DAI rate were to increase to 15% the fDAI present value (PV) would decrease from $0.98 to $0.927. This decrease in fDAI PV could be substantial enough to push the account leverage ratio above the maximum leverage ratio.

Let's note that Notional's interest rate curves have a maximum interest rate, thus partly mitigating this risk.

Liquidity risks

On-chain liquidity

The strategy is also subject to on-chain illiquidity risk. If the DAI/USDC on-chain liquidity was to decrease substantially, it could lead users to incur a large amount of slippage when redeeming their DAI for USDC. This risk seems well mitigated due to the existence of the Maker PSM and the amount of on-chain liquidity that is currently available for the DAI/USDC pair, but it still exists.

fCash liquidity

The strategy also carries some liquidity risk for early redemptions. For example, let's consider a user that wants to exit his position early. The user would have to sell his fDAI lending position on Notional, swap the DAI for USDC, and repay his USDC borrow. Exiting the strategy early will incur trade exchange slippage on the DAI/USDC, interest rate slippage and fees on Notional.

If there isn't sufficient liquidity in the relevant fDAI market for the user to sell his fDAI or if the trade incurs too much slippage, then the user would face illiquidity risk.

Let's note that this risk is only relevant before maturity as fDAI converts to DAI upon maturity.

Smart contract risks

The strategy interacts or is subject to the following smart contract risks:

  • Notional for borrowing and lending

  • 0x for trading between DAI and USDC

  • The value of DAI is dependent on Maker's smart contracts

Transaction costs

Entering the strategy

Upon entering the strategy, a user will have to cover for:

  • Notional trading fees, vault fees, and slippage on the borrowed currency

  • Swap fee and slippage to convert the borrowed currency to the lending currency (ex: convert USDC to DAI)

  • Notional trading fees and slippage on the lending leg of the strategy

Users must also cover the Ethereum gas fees related to entering the strategy.

Exiting the strategy early

Upon an early exit, a user will have to pay for:

  • Notional trading fees and slippage to redeem the lending leg of the strategy

  • Swap fees and slippage to convert the borrowed currency to the lending currency

  • Notional trading fees and slippage to close his borrowing position. Alternatively, the user could also just deposit the proceeds from the strategy against his debt such that it will automatically close when the debt matures.

Users must also cover the Ethereum gas fees related to exiting the strategy early.

Settlement

Upon settlement, when the vault reaches maturity, the strategy will incur the following transaction cost:

  • Swap fees and slippage to convert the borrowed currency to the lending currency

Settlements at maturity involve no trading on Notional as both the lending and borrowing positions have matured and converted to cash.

Users will have to wait for the settlement period to end in order to withdraw their assets from the vault.

Vault governance parameters

Strategy governance parameter

Historical return data

The historical rates data for DAI and USDC is accessible via Notional's data exporter under the "Markets history" tab.

Here is a link to a spreadsheet model allowing users to calculate the expected returns of the strategy while assessing its risks.

Emergency settlement

In case of an emergency, the protocol reserves the right to settle up to 100% of the vault if funds are compromised due to an active hack or a smart contract vulnerability.

An emergency settlement can also be triggered if the expected slippage to redeem the entire vault via a DEX aggregator such as 0x or 1Inch is larger than the vault liquidation discount. Under such a situation, it would be unprofitable for a liquidator to liquidate the whole vault. The emergency settlement acts as a way to ensure that the vault is always profitably liquidatable. This is key to making sure that the protocol is not subject to an excessive amount of risk.

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