Lemma is still in Beta and there are many different ways that the protocol could fail and result in a total loss of assets. Some of these risks are outlined below.

Long period of negative funding payments

As we saw in the yield section of the docs, historically, funding rates have usually been positive - even when there are as many longs as shorts. That said, past performance doesn't guarantee future returns. In order to have a long period of negative funding payments, there needs to be a bear market where a large majority of traders are shorting cryptocurrencies. This happened in 2018, and could happen again.

Risks for basis trading vault users (xUSDL holders)

When users deposit assets into the basis trading vault, they receive xUSDL (staked USDL) in return. That xUSDL represents the user's principal (deposited assets converted to USDL) plus the PnL (profits and losses) from the basis trading returns on: their principal + a proportional amount of unstaked USDL.
The PnL generated from the basis trading on the proportional amount of unstaked USDL acts as a floating, interest free, liquidation free leverage. This means that while it will work in favor of users during a period of positive funding payments, it will also work against them during a period of negative funding payments. It may be particularly dangerous in the following scenario:
  • A large number of users sense a long period of negative funding payments coming and withdraw their assets from the basis trading vault (unstake their USDL)
  • They keep their assets in USDL, thereby increasing the "leverage" for all remaining basis trading vault users
  • The increased "leverage" increases the losses incurred by each remaining basis trading vault user with each negative funding payment

Risks for stablecoin users (USDL holders)

Stablecoin users' main risk is not being able to redeem their USDL for 1 USD worth of cryptocurrency. In order for that to happen, the following four events would need to happen simultaneously:
  1. 1.
    Certain users may withdraw their assets from the basis trading vault if they believe funding rates will continue to be negative for the foreseeable future. If every user withdraws their assets from the basis trading vault (everyone unstakes their USDL) or if a basis trading drawdown eliminates all of the assets in the vault then Lemma will need to look elsewhere for assets to protect against any further losses.
    A large majority of basis trading vault users accurately predicting the start of a long period of negative funding payments is unlikely but not impossible. Furthermore, in order to avoid any negative funding payment, they may need to do so in advance, depending on the governance set โ€œunstaking timeโ€.
  2. 2.
    In case the event above happens, the Lemma treasury will be used to offset further negative funding payments. Over longer stretches of time, the treasury should theoretically grow to be quite large given the basis trading strategyโ€™s historical returns. However, as mentioned previously, historical performance is not always indicative of future results.
  3. 3.
    In case the negative funding payments wipe out all of the staked USDL and all of the treasury, the collateral backing USDL would start being affected. The worst drawdown for a basis trading strategy on Bitmex between January 2018 and May 2021 was 6% (compared to a 81% max drawdown over the same time period for BTC).
    In a hypothetical worst case scenario where:
    + Lemma starts issuing USDL at the beginning of that long period of negative funding payments
    + The treasury is empty
    + There are no assets in the basis trading vault
    Then, at the very end of the drawdown, USDL would be backed by 94% of its initial collateral. In this scenario, a user would only be unable to exchange a USDL for 1 USD worth of cryptocurrency if more than 94% of all USDL in circulation was redeemed beforehand.
  4. 4.
    Finally, if all of the events described above happen simultaneously, the protocol will still be able to mitigate the problem by using LEMMA tokens as backstop liquidity to compensate users while yields get back to normal.
As the treasury, number of users and total value locked (TVL) on Lemma grow, these series of events become increasingly less and less probable.

Derivative DEX risks

Lemma is built on top of various decentralized derivatives exchanges and as such, it is potentially vulnerable to an exploit of their smart contracts as well as a forced settlement of perpetuals.
In order to mitigate these risks, the Lemma DAO will need to decide what derivative dexes the protocol should integrate with, and assign them "risk scores" and "debt ceilings" (to cap the amount of collateral that can be lost on any given dex).
In case one of these problems occur, the events mentioned above (2, 3 & 4) will also need to happen in order for USDL users to not be able to redeem 1 USD of cryptocurrency for USDL.
Additionally, in the event that derivative dexes are not well arbitraged or do not have sufficient liquidity, it is possible that minting or redeeming a large amount of USDL could incur large slippage costs.

Smart contract risks

While Lemma has been audited by Peckshield, no product can be guaranteed to be always safe from exploits. Please do your own research and use at your own risk.