# The delta-neutral portfolio backed Stable Coin design

## Intro

Current designs of stable coins fall into two categories: reserve-based and algorithmic stable coins. Reserve-based designs are the most prevalent and proven method, further bifurcating into fiat-backed and crypto-collateralized stable coins. Fiat-backed coins like Tether (USDT) and USD Coin (USDC) continue to dominate the market, but crypto-based alternatives are gaining popularity due to their decentralized attributes. Notable examples include DAI and LUSD, which use ETH as collateral, and the more recent AAVE's GHO that supports multiple forms of collateral.

Crypto-collateralized stable coins' design typically involves an over-collateralization mechanism, whereby the total value of the collateral is more than the value of the stable coins issued. This over-collateralization serves as a buffer against the inherent volatility of the underlying crypto assets. For example, MakerDAO's DAI maintains a collateralization ratio (CR) of 150%, meaning for every $150 of ETH locked in a smart contract, $100 of DAI can be minted.

In pursuit of a more efficient and stable design for crypto-collateralized stable coins, we should strive to meet the following ideal characteristics:
* Lower Collateralization Ratio: The objective is to aim for the lowest possible CR, ideally achieving 100%, thus maximizing capital efficiency. This means that for every $100 worth of crypto-assets used as collateral, it should be possible to mint $100 worth of stable coins.

* Avoidance of Reflexivity: Reflexivity in crypto-based stable coins creates a self-reinforcing loop during market swings. In a bull market, rising crypto prices enables more stable coin minting, which further amplifies the price increase. Conversely, in a bear market, dropping crypto prices necessitate stable coin redepmtion, intensifying the price drop. An ideal stable coin system should neutralize these reflexive dynamics to ensure stability amidst market volatility.

## Delta-neutral Portfolio

An innovative design that aligns with the aforementioned requirements is the delta-neutral portfolio-backed stable coin. A delta-neutral portfolio is an portfolio comprises corelated financial products that retain their value despite fluctuations in the underlying asset's price. Ideally, such a portfolio maintains a delta of zero across all price ranges and times. When used as collateral, it allows for the full utilization of collateral for minting stable coins.

The concept of a delta-neutral portfolio-backed stable coin is not an original one. Before delving into the discussion of stable coins, we must first address several issues: the assets that can be used, the hedging tools that can be applied, the costs involved, and how the portfolio's risk can be managed. We will discuss each of these aspects in detail.

### Choice of Assets & Derivatives
The primary consideration is whether these crypto assets allow for the construction of a delta-neutral portfolio. Blue-chip crypto assets like BTC and ETH offer a wide array of hedging tools, such as margin trading, perpetual futures, and options. This might also extend to non-fungible tokens (NFTs), provided there are appropriate NFT perpetual contracts. Liquidity Provider (LP) tokens dispensed by Uniswap v2/v3 pools could also be viable due to their representation of a claim on a pool of two varied assets, thereby adding an additional layer of diversification and hedging possibilities.


### Cost Considerations
The cost of hedging can be divided into two categories. The first includes one-time costs, such as transaction fees and spread slippage. The second category involves ongoing costs associated with maintaining the position over time. This is particularly evident in the case of perpetual futures contracts where funding rates apply. Perpetual contracts might be the most suitable tool for building a delta-neutral hedge, as they typically involve longs paying shorts over the long term. However, due to liquidity factors, on-chain shorting costs are usually higher than those on centralized exchanges.

| Binance | Dydx | Perp | GMX |
|-------|-------|-------|-------|
| BTCUSDT |BTCUSD | BTCUSD |BTCUSD |
| 10.44% | 5.69% | -4.69% | -40.04% |

*The annualized median funding rate of each platform. The data was collected from January 1, 2023, to April 29, 2023. For GMX, the borrow rate was used.*

### Portfolio Risk Management
We presume that all assets will be used as collateral. As hedging essentially involves 1x leverage, this makes liquidation virtually impossible, ensuring the security of the overall assets. For instance, shorting a BTCUSDT perpetual contract on Binance with BTC as collateral entails a 5% haircut on BTC, effectively leaving 95% BTC as the effective collateral. In a scenario without other financial variations, liquidation would only occur at 18.18 times the opening price. If using inverse contracts on platforms like Bitmex or Deribit, 1X shorting has no liquidation price.

If for some reason – such as funding rate costs or a active position management that lead to less margin – liquidation becomes more likely. Therefore, a guardian role is necessary to help the system add or adjust positions before reaching the liquidation line, thereby avoiding unnecessary liquidations.

## Stable Coins backed by Delta-neutral Portfolios

With a suitable delta-neutral portfolio in place, how do we proceed to build stable coins?

Net asset value (NAV) stable coins could be an option. NAV stable coins can be minted and redeemed at the real-time net asset exchange rate. Their value fluctuation is entirely dependent on the profit or loss of the underlying portfolio. Thus, NAV stable coins initially have a net value of 1.00 and subsequently depend on the underlying portfolio's profit or loss. There is no re-peg mechanism. Therefore, NAV stable coins are entirely dependent on whether the underlying asset can maintain a zero delta consistently. Any fluctuation will reflect on the net value.

To actualize the stable coin's pegging mechanism, we need an entity to absorb the potential volatility, though small in most cases, of the delta-neutral portfolio. Such a role is common in most stable coin projects and is typically taken on by a governance fund or a stability fund. The stable coin minted from the portfolio should be redeemable for underlying assets equivalent to its face value (i.e., 1 US Dollar) at any time. Therefore, the stability fund undertakes the potential profit and loss of the delta-neutral portfolio. The stability fund's income comes from protocol earnings, management fees, and portfolio profits deposited in the stability fund. However, this clearly requires the stability fund to accumulate reserves through transaction fees, management fees, etc., and avoid hedging strategies that lose money in the long term.

### Stable Coin Factory
Based on different underlying assets and hedging methods, we can construct various delta-neutral portfolios. Although we strive to make these portfolios' delta equal to zero in the initial state, due to varying underlying asset volatility and different hedging costs, they will undoubtedly exhibit distinct long-term performance. Therefore, a stable coin manager could choose different portfolios for issuing stable coins, and we call this system a stable coin factory.

The architecture of the factory is as shown in the diagram. The protocol manager sets the underlying assets and hedging contract addresses. Any user can deposit the corresponding assets, each stored independently in a "trove", with each trove holding its corresponding hedging position. Troves can be either homogeneous or different, depending on whether they hold the same or different assets/hedging methods or whether they contain different delta-neutral portfolios, which depends on the manager's definition.


The operations of a trove include 1) user opening and closing positions that involve derivatives hedging operations, 2) the liquidation of positions is typically completed by the derivatives platform's keeper, and 3) in order to avoid liquidation as much as possible, a guardian role is necessary to monitor the liquidation risk and, before liquidation occurs, increase the trove's margin or reduce its position. Additionally, the trove's profits also need to be regularly transferred to the stability fund by the guardian.

The aforementioned operations often require an external actor to trigger or provide information, such as the keeper services used in some projects. However, to maintain the decentralization, keepers only serve as triggers for transactions. The on-chain system needs to independently verify whether all computations are correct. Therefore, if the logic is complex or involves a significant amount of data, the gas consumed for on-chain verification can be quite substantial. Moreover, the data source accessible on-chain is only the current block information, lacking historical block information, such as time-weighted average price (TWAP) data, the funding fee over a certain period, etc. This information cannot be provided using a traditional keeper mechanism. One solution to this issue is the use of zero-knowledge-based automated bots, such as zkAutomation.

### Positive-delta Stable Coins
Essentially, the delta target could be considered one of the stable coin parameters we're discussing. If the stable coin manager sets a positive delta target, say 0.05, then for BTC trove that hold one Bitcoin, only 0.95 units of a BTCUSD perpetual short position are held. This essentially means that the underlying assets of the stable coin are 95% USD and 5% BTC, establishing a floor value of 0.95 USD and retaining the exposure to the BTC bull. Consequently, the stable coin essentially becomes a portfolio of 95% stable coin + 5% BTC spot, so its mint/redeem price will not always be 1 USD, but should be determined according to the portfolio's price, excluding any hedging cost or hedging profit. Therefore, the stability fund still needs to exist to absorb these fluctuations.

# Conclusion

In this paper, we first deliberated the crucial factors to consider in building a delta-neutral portfolio. Then, we proposed a method for issuing stable coins based on a delta-neutral portfolio. The novel concept of a "Stable Coin Factory" offers potential for creating a diverse array of delta-neutral portfolios. However, significant challenges remain, such as computational complexity, high gas costs, and limited data access on-chain.