Convex Finance
DACM Special Situations Snapshot
Summary
- The stablecoin market is one of the largest in crypto with proven product-market-fit, settling between $7tn-$9tn of transactions per year;
- Curve Finance is baseplate infrastructure for decentralised trading in stablecoins and pools of pegged assets, with over $250bn in cumulative volume since launch;
- Convex Finance is an application which acts as a layer on top of Curve Finance, allowing liquidity providers to gain the financial (admin fees and tield boosting) and voting benefits (ability to direct CRV incentives to liquidity pools) of vote-locked CRV (veCRV) without the illiquidity that comes with locking CRV to create veCRV;
- The market value CRV emissions and they are a powerful tool for stablecoin manufacturers to use to bootstrap liquidity on Curve — Convex’s ability to direct CRV emissions is a key part of its value;
- Convex has long overtaken both direct competitors in StakeDAO and Yearn Finance for protocol owned veCRV, and, through the power it has in Curve voting power, has a highly reflexive flywheel which generates superior Curve yields through bootstrap incentives from stableicoin manufacturers;
- The upcoming launch of Curve’s stablecoin, crvUSD, combined with regulatory concerns regarding centralised stablecoins leaves Curve in a highly strategic position across the entire crypto ecosystem — DACM feels Convex could be an underappreciated asset to exert control over Curve and reap the rewards of this shifting stablecoin market structure.
Stablecoin Exchange Market
Digital dollars are the lifeblood of decentralised finance and are settling between $7tn-$9tn in volume annually as of writing — this is higher than total transactions settled by all credit cards combined, excluding Visa. The need to swap between fungible assets pegged to the same value in a frictionless, seamless manner is essential to the functioning of the protocol layer, and Curve Finance has emerged as the favoured solution for this since launching in Q3 2020.
Curve has experienced incredible growth in Total Value Locked (“TVL”) on its protocol since launch, experiencing a 15.9x rise from $315m to $5.0bn which positions it as the third largest application layer protocol across all chains (Lido and MakerDAO are first and second respectively). Although Curve Finance is a staple of DeFi infrastructure, it still caters to a niche audience having only 85,300 users on Ethereum, compared to Uniswap with nearly 5mn and Sushiswap with 1.2mn (based on various Dune dashboards).
On any given day, Curve averages users in the hundreds across all chains where it is deployed, and like lending protocols, Curve Finance serves a sophisticated crowd of users who are often positioned in multi-legged yield farming or arbitrage plays across the space, as opposed to tail-end speculation or unsophisticated spot buying. The result is that Curve is third, behind only Uniswap and Pancakeswap, for trading volumes on an annualised basis (as per The Block DEX volume statistics).
The largest threat to Curve is Uniswap v3, which has a capital efficient pseudo-orderbook implementation for swaps, allowing users to provide liquidity in tight ranges for the same stable pairs Curve relies on and for similar fees. Uniswap is now generating more stable pair volume than Curve, which is a potential concern for CRV and CVX holders going forward.
crvUSD
With the recent regulatory crackdown on stablecoins, particularly in the US with Paxos being the obvious example, the race is on to decentralise. Furthermore, the draft US stablecoin act that was released in the shadow of Luna’s collapse explicitly prevents endogenous collateral as part of a stablecoin’s backing. This frames the release of crvUSD — Curve’s own stablecoin — positively.
Curve aims to improve upon existing stablecoin mechanisms by integrating its own automated market-maker (“AMM”) into the system. More specifically, an innovation known as a “lending-liquidating AMM algorithm” or “LLAMMA”. The LLAMMA provides a dedicated market between the collateral asset and the stablecoin. Collateral provided to mint/borrow stablecoins is added to this market-maker rather than isolated “vaults” as popularised by MakerDAO. Not only does this provide a liquid market for the collateral and the Curve stablecoin, but more importantly it’s designed to serve as a continuous liquidation mechanism for collateralized debt positions (CDPs).
In current implementations of crypto-backed stablecoins (such as DAI backed by ETH), collateral positions are liquidated from vaults aggressively if the collateral falls past a critical threshold. With the Curve LLAMMA model, collateral positions will gradually liquidate as they approach danger. This is performed automatically by the LLAMMA, which slowly sells the collateral asset for the stablecoin as the collateral drops in value.
The advantage of this methodology is three-fold. First, partial liquidations reduce liquidity provider’s risk of total liquidation, and potentially lead to re-collateralisation of positions as assets re-price post-shock. Second, this mechanism means that crvUSD’s collateral contributes to its liquidity, creating a virtuous cycle. Lastly, Curve will earn fees as the pools trade amongst themselves to rebalance.
crvUSD is yet to be released but DACM is optimistic about its chances in gaining adoption. As discussed above, Curve’s position as a baseplate of DeFi all but ensures deep liquidity, which is the north star for any decentralised stablecoin project. FRAX and DAI, two obvious competitors, have a supply of c.$6bn — a large market opportunity that we expect crvUSD to penetrate.
Convex Finance
Convex Finance is a protocol which functions as a layer on top of Curve Finance, allowing Curve liquidity providers to gain trading fees (including future crvUSD revenues) and the yield boosting benefits of veCRV without the need to lock or own CRV themselves. Convex is idealised as a CRV black hole, as it permanently locks all CRV which comes into its possession. This occurs in two ways: either users deposit CRV and receive back a liquid version of veCRV called cvxCRV, or Convex gains veCRV through locking all CRV rewards the platform earns (distributing cxvCRV to stakeholders).
Convex will then use its pool of veCRV to boost the yield of users who have deposited Curve LP tokens on its platform. In return for this service, Convex charges a flat 16% performance fee on all CRV revenue generated by Curve LPs on the platform, with 10% going to cvxCRV holders, 5% going to CVX holders and 1% going as a bounty to reward harvester callers. The Convex design makes for an interesting flywheel:
CVX liquidity incentives → Curve LP TVL growth → CRV earned → permanent veCRV locked → higher yield boosting → CVX gains value (higher incentives) → more Curve LP TVL → more CRV earned → more veCRV locked
The design of the protocol has worked, as Convex overtook StakeDAO in only two days, and Yearn Finance in fourteen days for veCRV ownership, with Convex now owning c. 46% of all outstanding veCRV. This veCRV black hole also ensures that Convex will accumulate a wider moat as time goes on. This is due to the fact that the Convex model is reflexive as outlined above, and will result in veCRV being locked at a rate which becomes increasingly prohibitive to competitors as time goes on.
This strategy has since been applied to Frax Share (veFXS) accumulation as well to mixed results. Given the state of emissions, Convex could not be expected to attain the same dominance over veFXS as it did with veCRV, currently owning c. 16% of the total.
Token Model and Governance
There are two tokens in the Convex system — CVX and cvxCRV. CVX is the governance token of Convex, entitling stakers to a portion of the CRV rewards from Curve LP positions deposited to Convex (currently 5% of CRV rewards), as well as bribe revenue from third-party stablecoin manufacturers looking to build liquidity on Cruve and therefore buy the influence of Convex’s veCRV position. The liquid derivative of veCRV, cvxCRV entitles holders to the same distribution of admin fees and 3CRV rewards that regular veCRV gives holders. The difference is that staked cvxCRV holders will receive additional CRV through the platform performance fee, which is an additional 10% from CRV farmed by the protocol. This makes cvxCRV more attractive to hold than veCRV, as it has a more favourable liquidity profile and offers higher rewards.
Shift to Profitability
Convex’s success is obviously tied to Curve’s. DACM feel that with a structural shift in the importance of decentralised stablecoin infrastructure combined with the release of crvUSD, Curve is at the cusp of pivoting from a loss-making project to a profitable one.
DACM has prepared a high-level summary of Curve’s last-twelve-months (“LTM”) financials below:
Looking at Curve swap fees and including bribe revenues to predominantly Convex, but also Yearn Finance and StakeDAO, results in a c.$3.7m loss for the year after accounting for CRV emissions (note that this analysis excludes expenditure on team for both projects).
A worthwhile thought experiment is therefore to consider approximately how much crvUSD would need to be originated (assuming a conservative 1.0% interest margin) to turn the protocol profitable? Roughly $370m crvUSD, or c. 1/20th of the combined FRAX/DAI supply, would be enough to generate the $3.7m required. DACM view this as reasonably conservative given the potential liquidity moat surrounding crvUSD and particularly if demand for leverage returns to the sector.
As a control-layer sitting atop Curve Finance, Convex is set to reap the rewards of Curve’s success. Owning c. 300m veCRV means that any uptick in fees will flow through to Convex participants.
Potential Concerns
- Convex will be subject to market pressures acting on Curve Finance and will suffer if Curve continues to lose volume to competitors such as Uniswap v3;
- There are still c.20m CVX tokens yet to be emitted, but the portion for incentives is dwindling, which could jeopardize the cvxCRV/CRV peg which in-turn is a key driver of cvxCRV liquidity;
- At present, Curve may be over exposed to centralised stablecoins, primarily USDC, USDT, and partially DAI, which make up the notorious Curve 3pool — a pool that often accounts for ~50% of the protocol’s daily volume;
- Convex relies wholly on the Curve team (and the Frax team to a far lesser extent) to continue developing new, and iterating existing products that can compete within the market.
Potential Catalysts
- The potential of crvUSD becoming a decentralised settlement asset across DeFi, potentially taking significant share of the c.$135bn stablecoin market.
- Stablecoin volumes moving progressively on-chain as regulatory pressures push centralised actors away from the space, promoting Curve’s position as essential infrastructure.
- CVX governance implementation will continue to create competition amongst protocols to accumulate CVX for Curve gauge voting power, which will result in large amounts of CVX supply being taken off the market.
- A visibility catalyst will come when Convex is eating the majority of the new CRV emitted, and/or holds a majority of veCRV — close to being achieved.
Conclusion
Convex, through its ability to direct CRV emissions, has become the kingmaker of the Curve ecosystem and therefore, partially by default, stablecoin manufacturers that want to gain share in DeFi. Furthermore, it is our view that Convex is about to be subject to not yet digested narrative tailwinds — namely decentralisation of stablecoins and real-yield (i.e., profitability). DACM has been a long-time investor in both CVX and cvxCRV and view the position as a true expression of our belief in the product-market-fit of stablecoins. With the upcoming release of crvUSD, Curve has an opportunity to cement itself as the liquidity center of DeFi whilst significantly boosting revenues — something that Convex will benefit from greatly.
DACM’s funds and funds advised by DACM are investors in Convex Finance. This DACM Special Situations Snapshot is for general information purposes only and is not intended to be investment advice in any way.
