Discussion: The Reserve as a Liquidity Provider in the VCM

Mento
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Hi all,

CGP 31 added carbon credit tokens (cMCO2) to the Reserve (currently around 83k tons, ~450k USD, ~0.2% of total Reserve holdings). These carbon tons are effectively taken out of market circulation, supporting the demand for new credits and thereby financing new carbon removal/avoidance projects.

While this is in line with the Reserve’s theory of change and the overarching idea of natural capital backed currencies (1 2 3 4), we wanted to start a discussion about whether the Reserve can actually do more to support the on-chain voluntary carbon market (VCM) and ReFi assets more broadly.

In particular, with this post we want to discuss the possibility for the Reserve to become a liquidity provider in the on-chain VCM. This would mean that instead of holding carbon credit tokens directly, the Reserve would provide liquidity in relevant carbon trading pairs (or triplets, quartets, etc.).

This would have multiple advantages:

  • The carbon credits would not sit idle in the Reserve but would support a liquid on-chain VCM, allowing broader adoption of on-chain credits
  • The additional liquidity would contribute to VCM price formation and market efficiency, generating important price signals to VCM market participants
  • The Reserve would earn LP fees, boosting overall collateralization levels
  • It would introduce new ways for decentralized rebalancing of Reserve assets
  • It adds diversification benefits (price risk vs. IL risk - see below)

In terms of risks, it might affect the Reserve’s composition going forward (e.g., if the pool is continuously traded in one direction) and it gives rise to the risk of impermanent loss (IL). IL would occur if the value of the pool position decreases below the hypothetical value of simply holding the assets in the Reserve. Intuitively, IL arises because the AMM pricing formula (e.g., constant product) may not catch up quickly enough with external price developments, i.e. from a pool perspective some assets may be bought above market value and some assets may be sold below market value.

While LPing might be profitable even with IL (due to fees and additional incentives), we want to discuss the IL risk in a bit more detail. IL is minimized with pool assets that remain stable in value (e.g. two dollar-tracking stablecoins) or for pool assets that move in unison (e.g. two synthetics of the same underlying asset). By the same logic, IL is particularly pronounced with pool assets that exhibit divergent price developments. IL is unavoidable with an LP position consisting of one stable asset and one free-floating asset (e.g., CELO-cUSD), but is less pronounced between two generally correlated assets (e.g., ETH-UNI or CELO-UBE).

In general, it seems that there are two ways for the Reserve to introduce carbon pools:

  • Pools that involve CELO (e.g. CELO-cMCO2 pair)
  • Pools that involve only carbon credits (e.g. cMCO2 - other qualified carbon credits)

CELO-Carbon pools

Looking at the last 3 months, CELO decreased in value by roughly 75% (from $3.5 to $0.9). cMCO2 decreased by roughly 54% (from $10.4 to $4.8). This suggests a certain price divergence, which is not surprising given that cMCO2 should trade in the range of nature-based carbon credits and should overall be relatively less correlated with crypto markets.

To quantify the IL risk in more detail, @nirvaan kindly shared an IL simulation (see below), which suggests that IL risk would be fairly limited and would likely be compensated through LP fees in most cases.

The IL Matrix has the CELO token price on the Y axis and sample carbon-backed token price on the X axis. The values in the table show the IL (%) based on an initial LP deposit at CELO = $1.5 & Carbon Token = $12. Note that IL > 5% (red) essentially only occurs if one asset substantially appreciates in value while the other remains more or less unchanged.

IL (%) as a function of CELO ($) and Carbon Token ($)

Screenshot 2022-06-29 at 13.37.40
Screenshot 2022-06-29 at 13.37.401278×491 63.2 KB

Source: Climate Collective

Carbon-Carbon pools

There are currently no other carbon credit tokens on Celo and the only carbon credit that is currently approved as reserve asset is cMCO2. But major players in this space (Toucan and Flow) recently announced their launch on Celo, i.e. we can assume that other potential credit tokens will be available soon (Climate Collective can provide more overview on this). In the meantime, we can take a look at Toucan’s NCT token on the Polygon network to evaluate the IL risk of a hypothetical carbon pool with cMCO2 - NCT. According to Sushiswap Analytics data, NCT decreased over the last three months by roughly 51% from $7 to $3.4, which is largely in line with the price decrease that we observed for cMCO2 (54%). Extrapolating the logic above, this suggests that IL risk would likely be even lower for a carbon-only pool.

It seems that this could also be an elegant model for the Reserve to expand its natural capital allocation going forward in light of ongoing liquidity challenges. For example, the Reserve could introduce a ‘liquidity matching’ policy (subject to some upper bound): contribute X% to available liquidity but limit overall exposure to Y%.

For example, let’s assume X=25% and Y=3%. This would limit the Reserve’s total exposure to 3% (around 6M USD at current Reserve levels) but would make the actual exposure contingent on existing liquidity. Let’s say there is 10M USD in liquidity in relevant carbon assets. According to the suggested liquidity matching policy, the Reserve would contribute 25% of 10M USD = 2.5M USD in liquidity. If there is only 1M USD in liquidity, the Reserve would contribute 0.25M USD and if there is 100M USD in liquidity the Reserve would contribute 6M (upper limit is binding).

As a starting point, we could explore a standard 2-token LP model for the Reserve to actively participate in the VCM. Once more carbon-based assets launch on Celo, we could explore multi-asset liquidity pool structures, e.g. using Symmetric. This has several advantages, including establishing trading pairs between each asset, earning arbitrage fees from rebalancing the pool of carbon assets, and allowing users access to a “carbon-index” while deepening the liquidity of all assets equally. This would also allow the Reserve to abstract from individual asset allocations to an allocation towards a pool of high-quality curated natural capital assets.

We would very much welcome any feedback, comments or suggestions. We would also love to hear your thoughts and suggestions on potential LP setups (DEXs, pool compositions, etc.) and the interplay with the recently approved CGP 62.

Mento team

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I think this is a great proposal and in my understanding would indeed have a larger impact on ReFi assets than simply holding the assets. And if the reserve value permits there could be both assets and liquidity positions in the reserve.

With regard to CGP62 LP positions probably have to be allocated as a percentage of the ‘remaining reserve’, not the full reserve? With the remaining reserve being the reserve value minus USDC, DAI, and CELO.

I’m also thinking about whether impermanent loss (IL) would be an additional risk of that liquidity providing approach or if the reserve is subject to it anyways. Is a continuously rebalanced portfolio subject to the same impermanent loss as a liquidity providing position?

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Nice idea.

Is there a way to segment the reserve into different vaults, for lack of a better word.

What I’m trying to look forward toward is the regulatory requirements that will be likely for the reserve. Want to avoid co-mingling ‘invested funds’ with the ‘1:1’ backing of the stables.

Part of my underlying thought here is that if the stable coins are formally backed 1:1 by a fully segregated pool of assets that are ‘acceptable to regulatory bodies’ then: the rest of the reserve’s assets become technically ‘irrelevant’ to the stable coins except for mechanical uses like CELO being used back and forth in the minting process.

If we reach that formal status, then IMO we are very close to being able to say that essentially all the BTC and ETH in the reserve could be re-deployed into whatever other projects suited Celo’s best interest.

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If you do smart active LP in Uni3, you might make more from the reserve capital than the passive rebalance. When Uni3 comes to Celo, cLab need to come up with a good market making algorithm to manage the LP positions.

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@Slobodan and Mento team - thank you for putting forward this proposal. I welcome the thinking around leveraging LP positions in the Mento reserve to increase liquidity for natural assets on Celo. Particularly excited about the potential for multi-asset natural asset pools.

I’d also be supportive of an increase in the % of natural asset in the reserve (thanks @nirvaan and Climate Collective for your work on this!) towards the longer term goal, and great seeing the data you shared.

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Thanks everyone!

Yes and this is very much in line with what is currently discussed also within the Mento team. Overall, the idea would be to separate assets that are used for immediate issuance & redemption from other assets (e.g. impact assets).

In a sense, this was partly implemented through #CGP62, which essentially splits the reserve into a primary reserve (USDC/DAI + CELO) and a secondary reserve (BTC, ETH, cMCO2). The secondary reserve only holds assets if the primary reserve is sufficiently collateralized (2x under CGP62). This is also roughly in line with the ‘x < R < X’ framework that was briefly discussed here but it’s not quite there yet.

In my opinion, we should expand on CGP62 and the ‘x < R < X’ framework but make it asset or asset-group specific. This would essentially mean that there is a primary reserve (immediate issuance + redemption) and multiple sub-reserves/vaults with vault-specific liquidation and collateralisation parameters. It’s probably best to discuss this in a stand-alone post but just wanted to mention that this is something the Mento team is actively working on.

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