USDL is a stablecoin backed by a long spot and short futures position. The price fluctuations of the underlying spot assets are “canceled out” by a corresponding short futures positions. As a result, the portfolio backing USDL is stable in USD terms.
This sort of portfolio is called “delta neutral” or “market neutral” as the price movement of underlying spot assets has very little to no impact on it. This means USDL can be backed by any spot cryptocurrency asset, as long as LemmaSwap can short the asset’s futures on a decentralized exchange.
USDL backed by a delta neutral position
The futures instrument LemmaSwap uses to hedge deposited spot assets is called a perpetual future. Perpetuals are futures with no expiration date. Their prices are pegged to the underlying spot asset via funding rates - a fee traders on the “popular” side of the trade pay to the ones on the “unpopular” side of the trade. ie. If long traders are taking liquidity more aggressively than short traders, then long traders will pay a small fee every hour to short traders (and vice versa).
There are three ways of minting USDL:
- Deposit USDC.
- Deposit an asset supported as collateral on an integrated perpetual futures DEX. In this case, the deposited assets are used as collateral to open a short of equivalent size.
- Deposit assets that are not supported as collateral on integrated perpetual futures DEXs. When users deposit such assets, the following steps are executed:
- If USDL has USDC (or other USD stablecoins) on its balance sheet:
- The USDC on the USDL balance sheet is used to open a short with the same size as the USD value of the tokens deposited
- If USDL doesn’t have USDC (or other USD stablecoins) on its balance sheet:
- Half of the assets deposited are sold on an aggregator for USDC
- The USDC is used as collateral to open a short equivalent to 50% of the USD value of the deposited assets
Let’s imagine the USDL price in the ETH/USDL spot market goes down to 0.9 USD. A rational trader then would:
- Buy USDL with ETH
- Redeem each USDL for 1 USD worth of ETH on Lemma
- Repeat the process with the newly acquired ETH until USDL is worth 1 USD again
This arbitrage yields an instant ~10% return on capital with each completed loop, without taking into account gas fees and the price increase from 0.9 USD to 1 USD. This arbitrage also works the opposite way (to decrease USDL price) and with other forms of collateral to mint or redeem USDL for (eg. a mix of USDC and wBTC).
As we saw above, USDL can be backed by a position that consists of 50% spot assets and 50% of a USDC backed short. eg. 100 USDL can be backed by $50 worth of spot ETH and 50 USDC shorting ETH with no leverage.
If no action is taken and the price of the token increases by more than ~88.24%, LemmaSwap could get liquidated on this short. However, by rebalancing & selling some of its spot ETH for USDC and adding that USDC to the margin, LemmaSwap can avoid liquidation. LemmaSwap can do so by setting up range orders on the spot DEXs it uses, thereby avoiding unnecessary slippage and paying "taker" fees.
There is however a risk factor: perpetual futures DEXs often use oracles to determine whether or not to liquidate a position. Oracles get their price data from various exchanges, and if the price is not arbitraged properly between those exchanges and the spot DEXs LemmaSwap uses, there could be a disparity in price that could cause the rebalance to be more expensive than necessary & potentially even cause liquidations. This problem can be mitigated by running arbitrage bots between the spot DEXs LemmaSwap uses and the ones used by oracles.