Stablecoin Arbitrage with NUSD: Decentralized Price Discovery (Part 1)

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Introduction

The purpose of this article is to demonstrate how 1) Neutral Dollar (NUSD) is a better medium for trading vs. individual stablecoins, and 2) examples of how execution and price discovery can be utilized through the Neutral Dollar system.

To understand why Neutral Dollar is more opportunistic in utility than standalone stablecoins, we need to also cover the design of the Neutral Dollar and how it elicits better trading practices. Part 1 will be going over some mechanics of Neutral Dollar, drawing parallels from the traditional ETF product structure in why aggregation is useful for better liquidity and market making practices. We also outline how NUSD is distinguished from a traditional ETF, and why arbitrage is more practical on Neutral Dollar versus standalone stablecoins opportunities.

Part 2 outlines how a user can engage in stablecoin price discovery within the Neutral Dollar ecosystem. The examples will be didactic and not completely exhaustive — deeper market knowledge is required to perform these strategies effectively. Topics that will be covered are arbitrage within the tokenization layer, getting better execution quality on the underlying stablecoins through Neutral Dollar’s supported collateral, arbitraging against direct pairs on the basket exposure (issuance) , and cross currency (triangular) arbitrage with the Neutral Dollar system.

Basket Construction and Deconstruction

Neutral Dollar (NUSD) is a stablecoin that’s first of its kind — a stablecoin basket backed by existing stablecoins, initially comprising of USDC, PAX, DAI, and TUSD. The use cases are not redundant like standalone stablecoins — the intent of the instrument is to complement the growth of the stablecoin landscape, facilitate liquidity of underlying assets, and create a product that diversifies risk to serve as a natural hedge against a credit event. We can think of NUSD, or any basket Neutral product for that matter, as a decentralized ETF— where the purpose of the basket instrument is to aggregate liquidity, repackage risk, and provide a better exposure for investors. In the context of traditional ETFs (using in-kind activity as the sole example), the underlying assets are sourced by market makers (primary market activity), who then deliver the assets to an ETF issuer to swap for an equivalent amount of shares. The trader then takes the newly acquired ETF to exchanges to sell for investors (secondary market activity). The reason why this process works in an effective cycle is the distinction that the trader makes a market on the underlying, and makes a market on the exposure of the basket to the demand-side. These concepts are related but disjoint, since the seller and buyer are compensated differently with an ETF trade.

An example would be when a buyer of an ETF gets the benefits of a convenient exposure with a better risk-return characteristics, while the seller earns a slight premium for delivery of said exposure. The ETF exposure never deviates too far from the price of the underlying, since the market maker can actually create/redeem ETFs until the pricing between the assets and the basket are no longer dislocated by taking actions that result in risk-free profit (arbitrage). This process for ETF instruments is called price discovery.

Breaking down ETF trading activity, which is more dynamic and builds on existing market opportunities

Better Market Making Opportunities

What makes a basket instrument like ETFs so great for efficient price discovery is that liquidity is fueled on many different levels. More layers of liquidity between different markets presents better opportunities for arbitrage. Furthermore basket instruments are generally more accessible than the collective underlying assets, propagating liquidity further down and incentivizing market makers to purchase potentially illiquid assets.

A Neutral product builds upon this idea, and is designed such that it can be created using only one of the constituents, in exchange for the composite exposure and vice-versa for redemptions. The basket backing a Neutral product remains balanced due to a unique economic mechanism, and the benefits from this change allows for more dynamic liquidity of the underlying to address the different needs of market participants. Because of this, it’s actually easier to engage in price discovery activities due to less restrictive barriers. Since anyone can source only a single constituent, it is much easier to trade in a basket exposure for an individual underlying, given that it is much easier to price rather than pricing a collective group of assets and sourcing them all at once. Furthermore, exposure or inventory risk is reduced as the act of arbitrage in a Neutral product requires managing only one position at a single point in time vs. a composite group of assets which may fluctuate within the market.

When analyzed thoughtfully, we realize that Neutral Dollar is really a stablecoin of choice because of the mechanisms of how arbitrage functions in NUSD vs. how arbitrage works with underlying stablecoins. We can illustrate this by providing an example where many fiat-backed stablecoins advertise that these tokens provide a natural incentive to arbitrage. If a fiat-backed stablecoin is trading greater than a dollar, than supply increases, etc. However, this opportunity can fail for several reasons, simply because this process isn’t fully represented by the market nor is it completely observable by enough market participants to have pricing reflected properly.

Many stablecoins pose credit risk and the downside price movement is only more likely in the event of a default. In addition, fiat-backed stablecoins’s creation and redemption process is not instantaneous, and require operational hurdles + legalities that make dollar parity in a financial sense inaccurate (since not all tokenization processes are observable in the market for more accurate pricing). Many traders work with different fiat-backed stablecoins because of each individual stablecoin’s inefficiencies, but in doing so fragments the use of the stablecoin landscape. For example, exchanges that may list certain types of fiat-backed stablecoins may not see spreads tighten and lack price discovery due to higher maintenance to managing all of them, simply because there are restrictions that can close this opportunity. Many exchanges may not have the compliance to hold fiat directly, nor work with traders that can do it consistently all the time in proper denominations. Greater fragmentation elicits more inefficiencies, which needed to be acted upon but gets progressively difficult as users try to step in. A stablecoin solution that directly pools together opportunities can improve stablecoin liquidity and pricing in the markets.

Neutral Dollar, on the other hand, is built as a market instrument — comprising of assets where prices have some level of representation in the market more clearly with almost no lower bound in quantities. Any rational actor can interact with NUSD because all constituents as well as the basket product itself is reflected and accessible in the market or on the Neutral platform, thus presenting a more seamless way to engage in price discovery without ever involving in a process not dictated by market pricing. A unifying solution by basketing stablecoin assets pools the liquidity together, and makes stablecoin trading much more effective because not only does it still present the same opportunities for arbitrage that have already existed, but trading stablecoins against the basket exposure is an additional layer to work against since it now becomes an easier relative value trade where pricing is more apparent. This is the key distinction — that arbitrage on Neutral Dollar works on a layer governed by relative value with better market pricing in a more exposed fashion, while still providing opportunity for arbitrage opportunities that existed prior. The result of such is that Neutral Dollar becomes an open-end product with lower volatility due to diversified exposures and greater liquidity due to the multitude of ways to make markets and tighten spreads.

We will be going over some examples on how better execution quality through Neutral Dollar can procure arbitrage opportunities within the system in Part 2.

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Stablecoin Arbitrage with NUSD: Decentralized Price Discovery (Part 1) was originally published in Coinmonks on Medium, where people are continuing the conversation by highlighting and responding to this story.