Dynamic hedging improvement on stable coin – Arturas Vaitaitis –

It is clear, however, that with any amount of collateral, there is always the price drop of ETH large enough to render the hedging strategy ineffective. This is a fundamental problem of the decentralized stable coins as they inevitably break down as price of ETH or other collateral coins approaches 0. We believe that the only sustainable solution to the problem is to be explicit about the ranges of the price fluctuation that the stable coin can sustain.

Large price moves will reduce the effectiveness of any given AVA hedge, but it doesn’t undermine the integrity of the AVA protocol because future contracts are independent of what happened to old contracts and will start with the new lower Ether prices. In contrast, a stable coin with a fixed pool of collateral (e.g. specified at the time of the issuance of the coin), will lose its link to $1 (break the buck), and collapse for sufficiently large price moves. In our opinion, such risk will prevent these strategies from taking off in the first place.

Handling tail risk of very large price drops

The solution to the tail risk problem with decentralized stable coin is a hybrid system. The AVA coin will provide protection against price fluctuation up to a maximum, while insurance for tail risk can be obtained from a centralized entity if such need arises. The main requirement for such a backstop is that it is not correlated with the crypto price (e.g. based on fiat, commodity or simply general credit of the sponsor).

A hybrid system is the most likely to succeed given enormous price volatility of cryptocurrencies and the huge uncertainty of how any particular strategy will perform over time. We already discussed fundamental “correlation” problem with decentralized stable coin. Another clear problem is scalability given the limited bandwidth of major block-chains, which we will tackle by allowing for off-blockchain aggregators in the AVA protocol. This will allow to seamlessly switch from mostly on-blockchain smart contracts for important transactions to mostly off-blockchain third party solutions (which are fully auditable using hashing techniques).

Even though our goal is to create a functioning marketplace for AVA coins as described below, the bootstrapping such market is not a given. We envision the possibility that AVA-H hedge contracts, and the insurance, will be provided initially by a sponsor (or a sponsor pool).

One of the thorny issues with market-based solutions to stable coin is when the market doesn’t exist or is very thin. To move the AVA process off the ground, we envision a bootstrap stage when a single counterparty will provide liquidity for the AVA contracts. The seeding of the AVA mechanism can be backed by a collateral pool (e.g ETH or fiat currencies), or commitment by a financial backer to facilitate transactions at the first stage of the rollout.

AVA coin

AVA is a new class of cryptocurrency that combines elements of a traditional coin with additional attributes of a portfolio and a market order. Two or more coins are merged into a smart contract as the result of order execution by the matching engine for a specified period of time, e.g. one week. The contract re-allocates the value of the portfolio between the coins according the to AVA protocol and either terminates at expiration of if one of the coins exceed the specified maximum value transfer. There AVA is:

1. A coin in its own right. As with Ether or bitcoin, the main use of the AVA coin is to generate economic incentives. For AVA the goal is to facilitate market transactions. In the simplest form, the liquidity consumer will pay the liquidity provider in AVA. In the traditional Central Limit Order Book (CLOB), the liquidity provider is willing to execute a transaction at a fixed price, while liquidity taker will execute at the available market. The amount liquidity taker is willing to pay in AVA will affect the priority of the execution, while the overall price of liquidity will be set to attract market makers. The parallel in modern financial exchanges in the Maker-Taker model. AVA will also be used in the more advanced AVA auction protocol to create economic incentives and create liquidity.
2. A portfolio: The AVA may contain a portfolio of other cryptocurrencies and other Ethereum-based tokens. At the minimum, it will contain ETH in order to pay for gas in the blockchain transactions and as the collateral for the orders.
3. An execution order with matching instruction. AVA will contain order information fields detailing the transaction. The fields will include the size of the order, leverage, the type of the order, time to expiration, amount of AVA to be used in the transaction and the optional preferred matching engine.

AVA will be the only method of settling our smart hedge contracts. It is embedded in the contract template and it the only way to create these contracts.

Smart Contract Implementation — Efuture

Two or more matching AVA orders will be combined in a smart contract that will perform transfers of ETH or other assets in the AVA portfolio according to a straightforward algorithm or a formula. External prices provided by trusted oracles or native price sources will be used as inputs. This flexibility allows to specify both simple exchanges and hedges as well as arbitrary derivatives.

The “hello world” contract in AVA protocol is Efuture — a contract that maintain the value of the AVA portfolio equal to USD 1 for a specified period of time or as long as each AVA coin in the contract contains ETH funds.

Efuture will contain

• The notional of the contract. E.g. $1mm
• An initial margin (collateral) in ETH that provides security for the contract. E.g. 10% of the notional. The margin will also determine the leverage of the position, 1:10 in this example. It will automatically serve as the stop-loss on the position as the contract terminates once the collateral is depleted.
• The collateral moves from one party to another according to a formula and one or more oracles. We start with the Dollar contract that maintains the value of in USD for the party
• At expiration, the ETH is distributed between the parties if price fluctuations were within a predefined range. If price of ETH drops more, the party A will accumulate all the collateral (ex fees), which would be below the desired value, and party B will lose all collateral.

AVA Auction protocol

AVA coin as a part of the AVA protocol will contain a definition of a market order. Using the example of Efuture contract, the auction protocol will describe how the orders to buy or sell Efutures will be handled.

Market evolve a variety of matching order protocols suitable for specific products and environments. For example, Central Limit Order Book (CLOB) is best suited for time-sensitive and liquid markets, such as stocks and financial futures. The goal is to create the best execution environment, that is to say the highest probability of matching buy and sell orders while simultaneously trying to eliminate information leakage that hurts market participants.

An auction is more suitable for less liquid conditions.Auction process is used for single events such as IPOs and art. Continuous auction addresses both lack of liquidity and the need for recurring transactions.

We believe the AVA auction protocol is the most suitable for the blockchain ecosystems because it is designed in a distributed manner, avoids the front-running problems for simple protocols given that all information on blockchainэ is public, and handles latency of the Ethereum by spreading the collection of trading orders over a number of blocks, before matching the orders on the last block. After the matching is done, the Efuture contract is created for each orders that were successfully matched, and the collection of new orders resumes. The auction process is therefore continuous.

Periodic auction fits well for the blockchain-based markets market because of block generation cycle (15 seconds in Etherium).

In the AVA auction protocol for AVA orders sellers and buyers will send an order attached to AVA coin. Once orders are collected over a specific number of blocks, e.g. 100, and the matching will occur on block 101. The matching algorithm will satisfy all orders given the price-limit constraints and in the order of preference determined by the total amount of AVA the order is willing to pay for the transaction.

Anti-Gaming Measures

To make AVA auction market place a safer place we have designed a safety feature we call a collateral reserve. It makes gaming the market place more expensive than playing by its rules.

To understands what are safety features for, consider the scenario of market participants who want to buy Ethereum. The market benefits from the bidders staying in the auction until all the bids are matched. If however a bidder realizes that the prices are not favorable, that bidder can back out of auction at the end of reservation time, when all the bids are revealed. This is a case of asymmetric knowledge, where bidder who backs out has an informational advantage over people who stay in the auction. There are other types of market misbehavior and market manipulation, such as front running, trade washing.

There could be more safety features, such as

• Minimum execution size
• Auction time duration randomization, aka speed bumps

Blind Auction Implementation

Blind auction will contain 2 periods: bidding period and matching period.

The bidding period lasts for many block cycles. It gives enough time for a client to send a hashed version of the bid/offer. During bidding period a client does not reveal prices and quantities. Hash algorithm will be used to prove clients commitment to the order represented by AVA contract. In the end of the bidding period, the matching period starts when the clients instruct AVA contract to reveal their prices and quantities. The clients will send prices and quantities unencrypted and the protocol will check that the hash value checks out and the order that is being matched corresponds to the bidding period.

Another version of the auction will have a matching oracle that will keep all the private keys for AVA contract and there will be three time frames: bidding, matching and audit. In the end of the contract no price/size information is revealed. Matching is done by oracle that has all the private keys to conduct matching and execution of the contracts.

In the end to prove that oracle has done correct job, all the information will be revealed to a protocol at which point AVA protocol can invalidate or “bust” the trade if there was any error in processing.

AVA matching logic

The order flow chain starts with AVA contract order. AVA is assigned with the committed hash.

• Side: buy or sell
• Amount of AVA
• Indicative price
• Stop-loss price for the Efuture contact
• Size: amount of Efuture contracts

Each 100 blocks AVA protocol collects all the outstanding commitment hashes for each AVA contract order. Each AVA contract is not active until the contract is loaded with AVA coins. Once the matching timer expires, all of the activated AVA contracts are fed into matching algorithm. The matching algorithm looks for crosses in indicative price.

For all crosses it creates another matching contract with exchanged Efuture and Ethereum.

Features of a good market

In the Art of Designing Market, Alber Ross, an engineer turned Nobel Prize winning economist identified three features of a good market:

1. Thickness, “that is, to bring together a large enough proportion of potential buyers and sellers to produce satisfactory outcomes for both sides of a transaction.” In financial jargon thickness is liquidity. Lack of liquidity is the main problem that AVA protocol is designed to solve and is the point of failure of many unsuccessful attempt to introduce derivatives in Ether.
2. Safety. “They need to make it safe for those who have been brought together to reveal or act on confidential information they may hold. When a good market outcome depends on such disclosure, as it often does, the market must offer participants incentives to reveal some of what they know.” Transparency is embedded in public blockchain protocol, and is intrinsically valuable. AVA embraces transparency of Ethereum, and is not attempting to solve the “non problem” of secrecy. In fact, we welcome development of alternative contracts, matching engines and oracles as larger opportunity set and volume is exactly where the value of AVA is coming from. AVA, however, easily allows confidential negotiations such as “blind” auctions where the bids are submitted as hashes, so that the actual bids are not revealed in advance of the auction.
3. No Congestion. “They need to overcome the congestion that thickness can bring, by giving market participants enough time — or the means to conduct transactions fast enough — to make satisfactory choices when faced with a variety of alternatives.” This is a very important objective easily misunderstood. Speed is not a goal in itself and in fact can often be of dubious value, for example, in the race to the bottom in high frequency trading. Congestion is a “good problem” to have in nascent illiquid markets. However it is an issue given poor synchronization between the blockchain and the outside world and the large latencies. A careful design and a marketplace for the oracles is the key aspect to address the congestion problem. The incorporation of frequent-auction matching engines in the protocol mitigates this potential problem.

Future of AVA protocol

Our long term vision exceeds merely maintaining a stable coin or hedging, but rather provides the ability to short various cryptocurrencies. Short selling is selling security that you do not own. To short sell, security must be borrowed and then sold. To liquidate short position, one must buy it back and return to the borrower. Short selling is prompted by a bearish view on a market for a particular security, in our case a belief that a cryptocurrency will drop in value.

Shorting appears as a predatory activity, but like predators in the natural ecosystem, short selling serves a vital role to quickly liquidate or suppress cryptocurrencies that are malicious, badly designed and destined to fail.

AVA protocol easily translates to indices other than the USD. The only step would be to clone the existing setup and substitute the USD/ETH oracle for anther external oracle. Another advantage would be the ability to hedge to the price of gold or the EUR, currently an impossible task with more rigid fiat-based stable coins. Future endeavors include portfolio tracking equity indices and other more complicated derivative products.

Implementation.

Proof of concept working prototype for AVA auction mechanism including multiple bids, the auction and generation of smart contracts has been implemented on test net in Solidity. The code exists on github. For the access please contact us (see below).

How to contact the AVA team.

Please feel free to contact me, Arturas Vaitaitis, co-founder of AVA, New Jersey at AVACoin19@gmail.com