Volatility Insurance and the MakerDAO platformby@yotamyachmoorgafni
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Volatility Insurance and the MakerDAO platform

by Yotam GafniFebruary 24th, 2018
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I will reintroduce the idea of <strong>Volatility insurance</strong> -

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I will reintroduce the idea of Volatility insurance -

If a merchant can’t take the risk of large daily margins in a cryptocurrency value, he could pay a financial entity a commission for ensuring him the same rate over the day or determined period of time, so that he will not suffer the currency volatility while he’s serving as an intermediary between his suppliers and customers. Thus, this issue can be solved not by manipulating the currency as a whole but rather as a proprietary service offered by third parties to users of the currency.

The thing with volatility it can have an upturn and a downturn. Merchants don’t want to be suspectible to these changes, because it messes and disrupts their trade. Insurance companies though, with the use of statistics, by spreading the volatility risk between many players and having a large financial backing can withstand and make profit out of these fluctuations, assuming they can predict the overall behavior of the currency — whether it’s going up or down, and at what rate to set commissions paid by the merchants.

Volatility insurance in a smart contract

Say I am a merchant who received 10K$ worth of ETH, and I want to ensure that in the next period of time of commerce they will be pegged to the value of the USD. I will need to choose from the following parameters:

  • How much volatility am I protecting against. Is it the price of ETH going down x2, x3, x4.
  • How much fee am I willing to pay as a percent of the insured value.
  • What period of time should this insurance apply to

This can be standardized.

On the other side of the bargain, someone who wants to go LONG the value of ETH or believes some fee is sufficient for the risk, would supply me with the needed collateral for this insurance.

Say the parameters chosen are x3, 0.1% fee and 1 day of insurance, and the current price of ETH is 1000$.

The merchant will send 10.01 ETH to the smart contract. The insurer will send 20 ETH as the collateral. The 0.01 ETH fee will go immediately to the insurer, and the funds will be held in the smart contract for 1 day.

After 1 day, say the price of ETH has dropped to 500$. The merchant has done a good deal in this case. He will receive his 10K$ worth of ETH — now being 20 ETH. The insurer will get back the rest, which is 10 ETH.

After 1 day, say the price of ETH stayed the same at 1000$. The merchant gets back his 10 ETH, the insurer gets back his 20 ETH.

After 1 day, say the price of ETH went up to 2000$. The merchant gets 5 ETH, the insurer gets 25 ETH — This means that from 20K$ he got 50K$, so he was going LONG with x1.5 leverage.

Before the day ends, say the price of ETH drops at some point to 333$. This requires liquidation of the insurance, as the collateral is just enough to supply the merchant with his original worth of 10K$. He will get all the ETH in the smart contract, and will need to re-establish a volatility insurance if he wants to keep on pegging his ETH to USD.

Note that the merchant should be able to withdraw his worth of 10K$ at any point. He will then lose the protection of the insurance. The insurer can’t do that as he already received the fee he required. This is meant so that merchants will not be locked out of their coins in case they need them for commerce, and is consistent with the way shorting works in general.

It goes without saying but still important to note that this smart contract will require a system of oracles for knowing USD/ETH prices.

Volatility insurance vs MakerDAO

I think MakerDAO are almost there — look at this quote from their whitepaper:

Example 3: Alice and Bob collaborate using an Ethereum OTC contract to issue 100 USD worth of Dai backed by ETH. Alice contributes 50 USD worth of ETH, while Bob contributes 100 USD worth. The OTC contract takes the funds and creates a CDP, thus generating 100 USD worth of Dai. The newly generated Dai are automatically sent to Bob. From Bob’s point of view, he is buying 100 USD worth of Dai by paying the equivalent value in ETH. The contract then transfers ownership of the CDP to Alice. She ends up with 100 USD worth of debt (denominated in Dai) and 150 USD worth of collateral (denominated in ETH). Since she started with only 50 USD worth of ETH, she is now 3x leveraged long ETH/USD.

This is extremely similar, but has quite a few downturns compared to the volatility insurance smart contract described above.

The thing with MakerDAO is, Free markets are about voting with your feet, not about getting a vote to how the financial system will work like MakerDAO offers with the MKR token. In a free market, you can choose your own ‘stability fee’, and your own requirements for the size of the collateral in a CDP you’re committed to, not only have a vote in their governance. In the MakerDAO system, it’s either you accept the ‘rules of the game’, or you’re out. You can’t find a match who accept the same terms as you do and go with them.

This also allows flexibility when the markets turn whatever way. Because there are many different contracts with different settings, there isn’t a moment in time where everything is liquidated together, causing huge chaos. Also, in these cases in MakerDAO, all the biddings need to happen at the moment of crisis, when time is most important. In Volatility insurance as described, the bidding happens at the start, and from there on the mechanics is clear.

Generally in MakerDAO, the mechanics of the platform are so unnecessarily complex, with at least 3 different proprietary coins involved at the moment (PETH, DAI and MKR). The white paper hints at the architecture of the coin but doesn’t put forward the specifics, which are probably still being tested and changed, so an exact analysis can’t be made. In the Volatility Insurance, you know exactly what you get.

There is a kind of dualism to markets that enables us to understand them better. There are buyers and sellers. When you see someone shorting an asset, then you have the other side of the bargain who’s gaining a fee for the loan. You can believe both of them are rational, only with different estimations regarding the future. In MakerDAO, there is no clear ‘other side of the bargain’. It’s like Bob would bet against himself, short and long the DAI at the same time. We ask him to add a collateral, and pay a fee.

Volatility insurance contracts are USD on the blockchain

A Last thing to notice -

Once a merchant closes his funds in a Volatility insurance with given risk parameters, he can transfer this asset to anyone he wishes. This can be encoded within the smart contract. And what would you pay for 10K$ worth of ETH with x10 volatility insurance and the fees already paid for 1 year ? Probably just about 10K$. So they can be circulated around the blockchain as the actual asset they’re pegged to, and this was achieved without any central entity such as Tether, and without generating many different coins in many names.

Of course there’s no reason to limit yourself to USD, this can be any outside asset whose price can be oracled into the smart contract.