This article might be the most important one that you will ever read about the Hegic protocol. The HEGIC token, staking and liquidity mining matter. But deep understanding of the protocol’s risks can be an extremely valuable long-term knowledge for every token holder and user.
These are seven potential risks that you should be aware of if you are considering using Hegic protocol, providing liquidity to the pools, buying options or interacting with HEGIC token.
- Potential losses on selling options as a liquidity provider.
- Sending funds to the contracts instead of calling their functions.
- Funds provided to the pools are locked for 14 days.
- Inability to withdraw funds when liquidity pools are maxed out.
- Transferring write ERC20 tokens to other addresses.
- ChainLink ETH/USD and BTC/USD price feeds potential issues.
- Unexercised options’ profits (if any) will be lost after expiration.
1. Potential losses on selling options as a liquidity provider.
Selling options as a liquidity provider is not the same process as lending funds out using DeFi lending protocols. Liquidity provididers can lose money provided to the pools because they are being paid by buyers for obligations to buy or to sell assets at a fixed price during a certain period.
Example:
Ten liquidity providers have deposited 1 ETH each to the ETH liquidity pool (10 ETH in total). New options holder buys a call option of 10 ETH with one week expiration and a $400 strike price ($4,000 is the size of this option).
During the period of holding the price of ETH rises to $440 and the holder exercises it. She will receive the difference between the market price ($440) and the strike price ($400): $40 * 10 = $400 in ETH. At the moment of exercising the price of ETH is $440: 0.909 ETH is the equivalent of $400.
These $400 (0.909 ETH) is the profit of the holder and the loss of ETH pool that will be distributed pro rata among the liquidity providers. Each of them will suffer the loss of -0.0909 ETH (-$40) because in this example we have 10 liquidity providers (each has provided 1 ETH to the pool).
Liquidity providers’ capital allocated in the pools is at risk. Never deposit funds to the liquidity pools that you can’t afford to lose.
2. Sending funds to the contracts instead of calling their functions.
One should understand how contracts that are built on Ethereum work. Contract does not “understand” what kind of operation a user wants to do if a proper function of the contract has not been called. The liquidity pool contract will not “understand” what you want to do if you just send funds to the contract address. Options contract will not “understand” what kind of option you want to buy if you just send money to the contract address.
If you will send funds directly to the contracts addresses, you will lose it all without any possibility to get your funds back. If you don’t know how to interact directly with contracts always do it on https://www.hegic.co/.
Never send funds directly to the contracts addresses.
3. Funds provided to the liquidity pools are being locked for 14 days.
After depositing funds to the pool on Hegic every liquidity provider has an obligatory funds lock-up for 14 days. During this period of time she can’t withdraw funds from the pool. If a liquidity provider deposits additional liquidity to the pool during this period, the lock-up will be renewed and she will have to wait for another 14 days to withdraw funds from the pool.
Never deposit funds to the pools if you can’t afford to lock them for 14 days.
4. Inability to withdraw funds when liquidity pools are maxed out.
Options contracts are collateralized. When users buy options contracts liquidity equal to the size of an option will be locked for a period that the buyer has paid for. During this period liquidity won’t be available neither for new options contracts purchases nor for withdrawing by liquidity providers.
Maximum utilization rate of the pool is 80%. 20% of liquidity in the pools are always available for withdrawals by liquidity providers. However, the size of liquidity provided to the pool could be higher that the one wants to withdraw.
Example:
A user provides 100 ETH to the ETH pool. Total size of the pool is 300 ETH. New holders are buying options contracts and utilization rate reaches 80%. Now this liquidity provider wants to withdraw her funds. However, at a 80% utilization rate and the total pool size of 300 ETH only 60 ETH will be available for withdrawals. It means that this liquidity provider won’t be able to withdraw 100 ETH at once. She will be able to withdraw 60 ETH and will have to wait for active options expirations to be able to withdraw the remain.
Never provide more funds than the amount you can withdraw at any moment.
5. Transferring “write” ERC20 tokens to other addresses.
When providing funds to the liquidity pools, users receive “write” tokens (for example writeETH for ETH provided to the pool) that are minted at the moment of joining the pools. These tokens set user’s share in the pool. User’s share in the pool can grow or decline with time depending on the dynamics of the pool’s liquidity utilization, options traded and premiums accumulated.
“Write” tokens represent an on-chain guarantee that their holder has provided liquidity to the pool and has a share in its profits and losses distributed pro rata among LPs. The share in the pool is linked to these tokens, not to the particular liquidity provider’s Ethereum address. If a liquidity provider sends these tokens to someone else, she won’t be able to withdraw funds from the pool no more. Instead, a new “write” tokens holder will be able to withdraw all the funds provided to the pool earlier (plus or minus P&L accrued).
Never transfer “write” tokens to other people’s addresses.
6. ChainLink ETH/USD and BTC/USD price feeds potential issues.
Hegic protocol relies on ETH/USD and BTC/USD reference contracts provided by ChainLink. Each of these reference contracts has 21 independent data providers that are providinf data on ETH and BTC prices. These are not custom self-made oracles built during a hackaton. ChainLink is a leader in the DeFi oracles space that provides state-of-the-art on-chain price feeds. Nevertheless oracles and external price data aggregation can be considered as a potential risk to the stability of the Hegic protocol. Worth mentioning here that from the day one of Hegic launch on 20/02/2020 and during the last six months there were zero issues, bugs or problems with ChainLink’s price feeds.
Never use the protocol if you consider ChainLink’s price feeds unreliable.
7. Unexercised options’ profits (if any) will be lost after expiration.
During the period of holding an option the price of an underlying asset can move into the in-the-money zone. When in-the-money, an option can be exercised with profits for its holder. Options holders should exercise in-the-money options manually.
Call options holders receive the difference between the market price and the strike price (which should be lower) at the moment of exercising an option.
Put options holders receive the difference between the strike price (which should be higher) and the market price at the moment of exercising an option.
Options holders can exercise their in-the-money options at any given moment during the period of holding (American-style).
Remember that you should exercise your in-the-money options manually.
Learn the rules like a pro, so you can break them like an artist.
Never deposit funds to the liquidity pools that you can’t afford to lose.
Never send funds directly to the contracts addresses.
Never deposit funds to the pools if you can’t afford to lock them for 14 days.
Never provide more funds than the amount you can withdraw at any moment.
Never transfer “write” tokens to other people’s addresses.
Never use the protocol if you consider ChainLink’s price feeds unreliable.
Remember that you should exercise your in-the-money options manually.
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