Brahma’s current product suite stretches far and wide to obtain yield sustainability and principle protection across DeFi. But the search for yield Valhalla continues. With $20k BTC and $1500 ETH becoming the new normal, our strategists summoned a strategy for the bera transition and it has everything to do with leverage and iron-clad risk management infrastructure while Pepo goes yield hunting.

With the unboxing of Gearbox v2, the search for seamless leverage opportunities and liquidity within the ecosystem is finally being set in motion. In an attempt to power up organic yield and gauge superior capital efficiency, Brahma drafted TopGear; a risk-management strategy vault for Gearbox V2 unlocking ultra-sound leveraged yield on $FRAX.

The Strategy

The strategy aims to earn the best-in-class yield on FRAX, the yield-farmers favourite stablecoin. It unlocks the power GearboxV2 by a taking leveraged long stETH, short ETH position against FRAX collateral to capture the difference between ETH borrow rates and stETH staking yields.  Brahma’s real-time risk management and execution infrastructure ensures the position leverage is actively managed to prevent liquidations while maximising returns.

Background

Ultra-Sound Yields

In the never-end search for yield, liquid staking derivatives (LSD) on ETH have gained enormous popularity after unlocking a native ultra-sound 🦇🔉 ETH yield and providing a simple way for users to put their ETH to work.

With the bear market taking hold, the bids for shit-coin emissions dried up and on-chain yields have been down only. Thus, the attractiveness of the native ETH staking yields has been ever-growing. Additionally, a number of strategies looked to generate even greater returns by taking leveraged exposure to these ultra-sound yields. Typically this involved borrowing ETH against collateral on a lending protocols like Aave, swapping the ETH for stETH (by far the largest and most liquid LSD), depositing the stETH on Aave and repeating. However, in the May/June crypto credit crunch in the aftermath of the Luna/UST collapse, the pegs of the various liquid staking derivatives experienced significant volatility since they were not yet redeemable for ETH. These strategies faced numerous forced de-leveraging events and even liquidations. In some cases, treasuries had to step-in to top-up collateral on the lending platforms to prevent getting rekt.

After the successful merge in early September, the timeline for the redeemability of these derivatives was significantly de-risked, consequently pegs re-rated and stabilised. Additionally staked ETH yields got the boost of transaction tips as well as potential MEV payments all while ETH issuance reduced (🦇🔉). This together with the continual decline of other on-chain yields has drawn even more attention to ETH staking yields as an ultra-sound source of yield.

Structural Opportunities

The structural opportunity that these leveraged staking strategies have looked to exploit is the dislocation between ETH borrow rates and the stETH staking reward rates. Clearly, this position is taking on stETH:ETH peg risk and thus a risk premium should exist. Prior to the merge, this rate differential sat around 2%.

In the immediate dates leading up to the merge, ETH borrow rates spiked as traders looked to benefit from possible PoW forked coins. Post-merge, the stETH yields have ticked up as expected with ETH stakers now receiving transaction tips and MEV payments. Interestingly, ETH borrow rates have settled back to pre-merge levels and the rate differential now sits around 3%.

With the timeline for the redeemability of stETH being significantly de-risked and the rate differential remaining elevated; it is a prime time to take advantage of this opportunity.

The Risks of Getting Pegged

While harvesting the difference in yields looks very attractive on a leveraged position; one cannot ignore the risks. This is especially true the more leverage that the strategy employs. Simply put, the position is a leveraged long stETH/ETH position and can thus face capital losses or even liquidations, that's the power of leverage.

A lot of these leveraged strategies gained popularity in the first quarter of 2022 and were considered “safe” under the misguided assumption that stETH:ETH would always trade close to 1:1 with ETH. However, with the credit crunch that followed the Luna/UST collapse, the market re-rated stETH’s illiquidity premium. Those strategies with aggressive leverage faced liquidations or were forced to reduce positions, locking in losses (buying high and selling low).

This volatility laid bare the need for risk monitoring systems to prevent liquidations and unnecessary losses. In addition, it can be seen that the peg volatility has reduced significantly after the successful merge; further highlighting the de-risking that has occurred and the opportunity that this strategy presents currently.

Collateral Choice

The majority of existing leverage staking products used stETH as the collateral asset. Liquidation risk was expected to be low given that stETH was expected to be very closely correlated to the debt asset (ETH). Strategies that used stablecoins as the starting collateral asset were less popular given the reduced capital efficiency (collateral yield is a drag on the overall yield) and the overhead of having to manage the additional potential liquidation events from ETH price movements.

However, in a depeg scenario having stablecoin collateral provides a much better risk profile. This can be seen by looking at the ETH and stETH:ETH prices during times of peg volatility. It can be seen that the depegs happened when the market was risk-off and so the ETH price was falling. This provides a strategy with stablecoin collateral an additional buffer since the debt asset is losing value against the collateral asset. This improves the position health factor and helps to offset the worsening health factor from the peg deviation. Crucially, this reduces the chance that a strategy has to reduce its position at a time when stETH is trading at a large discount and prevents locking in losses.

This right-way risk together with the falling defi native stablecoin yields provides a great opportunity to better unlock ultra-sound yields for stablecoin holders.

Gearbox V2 Unlocks

While the leveraged stETH strategies have been popular for a number of months, borrow-lending platforms had fairly conservative collateral factors for stETH. This was required since they would allow a variety of assets to be borrowed against this collateral. While this limited the amount of leverage these strategies could obtain it also meant that liquidation prices were relatively close even at leverages of 2x.

The launch of Gearbox V2, which adds infinitely more composability on top of the Credit Account innovations of V1, provides the perfect venue to unlock these yields with much-improved capital efficiency. Credit Accounts (CAs) are segregated based on the asset you wish to borrow; allowing for better capital efficiency since the risk of the collateral is evaluated against a single borrowed asset. For example, stETH can have a high collateral factor in a WETH Credit Account due to the high correlation between the stETH and ETH prices, lowering the risk to the pool and allowing for better capital efficiency.

To illustrate this, the maximum possible leverage is calculated for taking the long stETH, short ETH trade against USDC collateral on Aave, Euler and Gearbox V2. Note, leverage is defined here as the value of debt divided by the value of the collateral.

Furthermore, unlike Aave and Euler, Gearbox V2 allows FRAX, the yield-farmers favourite stablecoin, as a collateral asset: unlocking 🦇🔉 yields on FRAX for the first time.

Brahma’s Value Proposition

It should be clear that the successful merge and the launch of GearboxV2 provides a great opportunity for Brahma to demonstrate the power of the first of its new risk-management vaults. Staking yields have never been more ultra-sound, capital efficiency on FRAX has never been this high and stETH peg volatility has never been this low. Brahma aims to unlock all of this for users with a simple single-sided deposit with its automated risk-management and on-chain execution framework keeping funds sifu and hard at work.

Monitoring

The first step in running leverage strategies is adequate monitoring of the wide variety of parameters that will affect the position’s chance of being liquidated and its profitability. This includes:

• Standard position health metrics
• stETH:ETH Curve Pool Monitoring
  • Being the venue of choice for stETH liquidity, monitoring the health of the curve pool provides key insights into flows as well as exit liquidity and execution costs
• Oracle Prices
  • Gearbox Health Factors (and thus liquidation events) are based on oracle prices so monitoring these and their deviations relative to DEX prices, both past and present, are crucial in setting safe leverage bounds.
  • This is particularly important for this strategy since the stETH/ETH price implied from the ETH/USD and stETH/USD chainlink oracles can deviate significantly from the actual stETH/ETH price due to differing update thresholds and times.
• On-chain interest rates
  • The profitability of the strategy is driven by the difference in ETH borrow rates and stETH staking yields.
  • Monitoring on-chain rates helps ensure that potential structural changes in the market can be identified quickly and the framework adapted.

Risk-Management Framework

A clear, data-driven risk-management framework allows the strategy to operate safely and autonomously.

• First and foremost, user capital must be protected.
  • A hard limit for the position health factor is set which triggers de-risking to prevent liquidation in a Black-Swan event.
• Secondly, proactively manage position risk while limiting execution costs.
  • The position’s effective leverage is continuously monitored and managed in a range-bound framework.
  • The position leverage is used to assess the overall position risk by analysing the liquidation point relative to previous moves, the current health of stETH liquidity pools as well as oracle price deviations.
  • The range-bound methodology minimises execution costs and prevents over-trading by only adjusting positions if the range bounds have been breached.

Modular Architecture

Brahma’s module architecture allows for multiple trade executors to be added and managed by the vault.  It is important to note that Gearbox V2 doesn’t natively support partial withdrawals of collateral from a Credit Account. This means a user or vault has close their whole position in order to access any of their funds or profits. This can be especially gas intensive for a single user.

While this design choice limits the flexibility of a vault on Gearbox’s current architecture, the ability of TopGear to manage multiple credit accounts at once allows for partial withdrawals to be processed by only closing a portion of the overall vault position. Importantly, new deposit requests can also provide liquidity to withdrawers saving the vault from potential execution and gas costs.

Furthermore, the modular architecture enables the agile deployment of new strategies to ensure that best-in-class opportunities continue to be delivered. In the future, this enables the vault to execute multiple different strategies in different credit accounts to deliver diverse, risk-managed yields.

Strategy in Action

To demonstrate the Brahma risk management framework in action we backtest the strategy against historical data to see how it would've performed through the height of the stETH:ETH peg volatility.

Historical Data

For historical data we fetch the state of the stETH:ETH Curve Pool (reserves and virtual price) at fixed block intervals as well as Chainlink oracle prices for ETH and stETH. The curve pool state at each point in time is inputted into Brahma’s internal implementation of Curve’s StableSwap which allows for simulated trades with market impact and accounts for true execution costs.

Static historical staking yields and borrow rate are assumed. The focus on the backtest is with respect to the risk-management framework and rebalance costs.

Strategy stress test

The strategy deposits FRAX collateral to a WETH Gearbox credit account. A leveraged ETH debt position is created with ETH swapped for stETH. Target leverage is 4x (value of ETH debt / collateral value =  4) with a lower bound of 3x and upper bound of 5x. This strategy is tested from May 2022 to October 2022 which capture the largest peg volatility both during the post UST/Luna credit crunch as well as in the lead-up to and after the merge.

Since the position is leveraged long stETH:ETH it experiences a drawdown during the June depeg. The right-way collateral risk can be clearly seen as during the height of the peg stress, the strategy leverage actually breached the lower bound and the position had to be increased (more ETH borrowed and swapped to stETH). This allowed the strategy to benefit by buying more stETH when it was trading at its biggest discount.

To quantify this, the strategy bought a net additional amount of 169stETH at an average price of 0.973. This equates to an additional return of 6% given the peg price at the end of the backtest period.

Post Merge

We then test the strategy performance on post-merge data. With the reduction in peg volatility we increase the target leveraged to 5x with a lower bound of 4.5x and an upper bound of 5.5x.

Given the recent peg stability, one might think active risk management is not needed. However, ETH price volatility is still a factor and the position needs to be well managed.

With Brahma’s framework remaining data-driven the target leverage and leverage bounds can respond to structural changes in both stETH:ETH and ETH price volatility to ensure the strategy operates at the optimal intersection of responsible leverage and degen yields.

Strategy FAQs

Won’t borrowing rates be higher on Gearbox compared to Aave?

Since Gearbox offers a lot more capital efficiency to borrowers, borrowing rates may be higher on Gearbox than other borrow-lending protocols like Aave and Euler. That being said the Gearbox has an extensive liquidity mining program for the initial V2 launch which should increase depositor supply and keep rates at least in line in the short term.

How long will this opportunity last especially with ETH staking withdrawals soon to be enabled?

One could expect ETH borrowing rates to trend towards the native ETH staking rate once withdrawals are enabled with EIP4895 in the Shanghai update. That being said there will still be a withdrawal queue and given the additional risk that liquid staking derivatives carry it is possible that the difference in these rates persists. While the long-term sustainability of this strategy is not guaranteed, the current opportunity that it presents is compelling.

Why should I use Brahma’s TopGear instead of GearboxV2 directly?

You should use Brahma’s TopGear wrapper if any of the below apply to you:

• You want double-digit non-inflationary yield on your stablecoins
• You don’t want to wake up in the middle of the night and adjust your position because a picture of Vitalik’s dong pumped the price
• You don’t enjoy being liquidated
• You want gas costs completely subsidised for all Gearbox interactions
• You don’t meet the minimum borrow requirements to use Gearbox directly
• You want to stack $KARMA

Joining the strong suit of Brahma vaults, TopGear arrives on the 8th of November.
Karma 69 and above fren! Get ready, it's time to fraximise.

For more updates: Twitter | Discord

Disclaimer: The content of this post is provided for informational purposes only.

This article is not an offer of securities, an invitation to sell or a recommendation to subscribe for or purchase any securities, and it has been prepared without any consideration of particular investment objectives. Nothing herein constitutes investment advice or recommendation.