Risks

arcUSD is not designed to be a stablecoin, it is not the same as USDC or USDT. Rather, it’s a rebasing token that is soft-pegged to the dollar, reflecting a dynamic value tied to the underlying trading strategies and market conditions. This section outlines the inherent risks of engaging with arcUSD and the proactive measures Arcana takes to mitigate these risks.

Why arcUSD is Not a Stablecoin

arcUSD, while soft-pegged to the US dollar, does not guarantee a fixed one-to-one peg with USD nor $1 of redeeming value at any time. The peg is maintained through a combination of trading strategies, collateral management, and rebalancing mechanisms that aim to stabilize its value around one dollar.

The value of arcUSD is primarily influenced by the perpetual futures market, particularly through the backing assets’ perpetual contracts funding rates, rather than direct price movements of the underlying. In a delta-neutral strategy, Arcana protocol hedges its exposure to the backing assets’ price fluctuations by taking equal but opposite positions in the market, effectively aiming to have zero net exposure to price changes. This means the main risks for arcUSD arise not from movements in spot prices per se, but from the dynamics of the funding rates associated with these futures contracts.

Traditional stablecoins like USDC and USDT are very different products as they maintain their peg through straightforward collateralization backed by fiat reserves, US T-bills, or equivalent assets offering minimal exposure to market volatility.

arcUSD provides higher yields that come with newly introduced risks:

1. Trade Risk

2. Custodial Risk

3. Exchange Failure Risk

4. Impermanent Loss

5. Operational Risk

Trade Risks

Underlying Derivatives Risk

USDT is a fundamental component of the Arcana trade strategy. If Arcana were holding a short position denominated in USDT and that token were to depeg, that would result in significant loss of the short position. Exchange partners are not aways consistent nor clear in how coin-margined and token-margined contracts are denominated (USD vs USDT,) a USDT depeg could result in significant loss that isn't appropriately hedged.

Further, we don't trade in an isolated market, Arcana operates as a small part of a much larger derivatives market. Short sellers and other investors may move the market with impacts to Arcana which may not be fully hedged.

Basis Risk

A basis trade involves simultaneously taking opposing positions in the spot market and futures market for a particular asset. Since the spot asset and its corresponding futures contract trade independently, their prices can diverge from one another. The difference between the spot price and futures price is referred to as the "basis". Traders attempt to profit from basis trades by capitalizing on pricing discrepancies that may exist between the two related markets. However, risks may not always be perfectly hedged resulting in loss which may impact the value of arcUSD.

Funding Risk

Funding Risk pertains specifically to the potential for persistently negative funding rates in the perpetual futures market, which directly impacts the yield generated from the delta-neutral strategies conducted by the protocol. Funding risk arises when the costs to maintain a position, dictated by the funding rate of perpetual futures contracts, become a liability instead of a revenue stream due to sustained negative rates.

To address funding risk, Arcana accumulates 5% of all yields into the protocol Insurance Fund. The Insurance Fund principal role is to provide a financial buffer to counteract the impacts of negative funding rates or any unforeseen market disruptions that could significantly affect the protocol.

arcUSD is exposed to depeg by protocol design, since it’s soft-pegged to the dollar without the guarantee of $1 in redeeming value. Redemptions will be based on the current coverage ratio at the time of asset withdrawal.

Historical BTC funding rates

Since BTC forms the largest proportion of Arcana's backing assets, and the profitability of the Bitcoin cash and carry strategy hinges on positive funding rates, a thorough historical analysis of funding rates within the Bitcoin derivatives market is crucial. The charts below show that while negative rates do occur, they generally do not persist for extended periods

Other strategies such as Liquidity Pool Hedging derive yield from additional sources beyond funding rates (LP fees and rewards), so their profitability is not solely dependent on the funding rates, like it is in the case of bitcoin cash and carry strategy.

Custodial Risk

Arcana utilizes custodian services to manage the protocol's assets securely without direct engagement with centralized exchanges. This approach involves "Off-Exchange Settlement" (OES) solutions provided by our custodian CEFFU, with plans to expand to more custodians to diversify and mitigate risks.

Custodial risk revolves primarily around the operational capabilities and reliability of the custodian. There are some risks associated with using an OES provider for custody:

• Custodian Systems Reliability: Arcana's ability to effectively manage its operations, including depositing, withdrawing, and adjusting positions on exchanges, is contingent upon the custodian's systems being operational and responsive. Any disruption in these services could impact Arcana's trading workflows and the overall functionality of the mint/redeem processes for arcUSD.

• Operational Failure of Custodian: While large-scale operational failures or insolvencies among established crypto custodians are rare, they remain a possibility. Such an event could disrupt Arcana’s operations, particularly affecting the issuance and redemption of arcUSD. It’s crucial to note that assets held by custodians are in segregated accounts, thus, neither the custodian nor its creditors should have any legal claim over these assets. Custodians typically employ bankruptcy-remote trusts or use multi-party computation (MPC) wallet solutions to enhance security.

Exchange Failure Risk

Arcana utilizes centralized exchange derivatives markets to conduct delta-neutral yield strategies. Decentralized exchanges are currently not included in the protocol operations since the outstanding open interest across these venues is not considerable enough to perform such trades.

The risk of an exchange failure, like the historic case of FTX, represents a significant risk for the Arcana protocol.

Initially, Arcana will start shorting backing assets’ perpetual contracts only on Binance, with plans to expand to more centralized exchanges to diversify and mitigate risks. Binance is the leading centralized exchange by both assets held and derivatives open interest and volume.

Arcana minimizes direct exposure to exchanges through the use of a custodian who handles Off-Exchange Settlement. This setup means that Arcana’s backing assets are never directly deposited on an exchange, which significantly reduces the risk associated with any single exchange's failure.

Should an exchange failure occur, Arcana would quickly move to delegate the collateral to another exchange and hedge any outstanding delta that was covered by the failed exchange. This quick pivot is crucial to maintaining the protocol’s stability and ensuring continuous operation without significant disruption.

Arcana actively monitors the health and stability of its partner exchanges and is continually assessing new exchanges as potential partners to enhance liquidity and limit exposure to single source risks. The protocol takes a proactive approach to managing exchange relationships, ensuring that any associated risks are recognized early and addressed promptly.

Impermanent Loss Risk

Impermanent loss is a specific risk introduced by the Liquidity Pool Hedging strategy.

This occurs when there is a divergence in the price movements of assets within a liquidity pool. If the prices of the assets diverge after being deposited, this can lead to potential losses when withdrawing them compared to simply holding the assets outside of the pool.

Impermanent loss is essentially the opportunity cost of adding liquidity to an Automated Market Maker (AMM) pool versus holding the individual tokens. It typically occurs in pools where asset pairs exhibit significant volatility. The greater the divergence in price movements between the pooled assets, the higher the potential for impermanent loss.

Example: Consider a simple 50/50 liquidity pool with ETH and WBTC. Initially, suppose ETH is valued at $3,000 and WBTC at $60,000. If you contribute 2 ETH and 0.1 WBTC, each portion valued at $6,000, your total contribution is $12,000. If the price of WBTC doubles to $120,000 and ETH triples to $9,000, although the overall value of the pool increases, the disproportionate rise in ETH's price relative to WBTC results in impermanent loss because the price ratio between WBTC and WETH has changed since the initial deposit.

Arcana’s Approach to Managing Impermanent Loss

To mitigate the risk of impermanent loss, Arcana strategically selects liquidity pools with a lower risk of price divergence between the assets, thereby reducing the likelihood of significant impermanent loss. Additionally, since the liquidity pool positions are hedged with corresponding short positions in perpetual futures, these hedge positions are continuously rebalanced to align with the current value of the assets in the pool. This dynamic rebalancing helps maintain the delta-neutral position of the hedge, effectively reducing the financial impact of price divergence within the pool.

The primary goal of the Liquidity Pool Hedging strategy is to collect much more yield from the liquidity pool fees and rewards than the potential losses incurred from impermanent loss. By carefully selecting and managing liquidity pool allocations, Arcana strives to optimize the balance between risk and reward, maximizing returns while minimizing exposure to impermanent loss.

Operational Risk

In the process of minting arcUSD, several operational steps are involved, each carrying its own set of risks. Below, we detail each step of the process, identify the potential risks, and explain how Arcana addresses these risks, when possible.

USDC Depeg

Any shift in the value of USDC could impact the conversion from USDC to any backing asset. As USDC is backed by fiat reserves, US T-bills, or equivalent assets offering minimal exposure to market volatility, this is a low-risk situation.

Smart Contracts Exploit

Funds can be lost or stolen due to vulnerabilities in smart contracts, which are a critical component in the process of minting arcUSD. Arcana mitigates this risk by ensuring that all smart contracts undergo rigorous audits by reputable third-party security firms.

Additionally, Arcana's smart contract architecture is designed to be quite simple, with most of the complex actions happening off-chain, significantly reducing the attack surface. Ongoing security practices include continuous monitoring and updating of contracts in response to emerging vulnerabilities.

With the introduction of the Liquidity Pool Hedging strategy, new smart contract risks arise, as part of the assets used in this strategy are deposited into DeFi protocols' smart contracts. To address this specific risk, Arcana commits to only depositing assets into established, battle-tested DeFi protocols that have demonstrated the safety and reliability of their smart contracts.

LayerZero Cross-Chain Messaging Failure or Exploit

As arcUSD is bridged from re.al to other chains using LayerZero cross-chain messaging protocol, any exploit or failure caused by LayerZero could impede the process. LayerZero uses simple and effective design to its bridging mechanism reducing security risks to a minimum. LayerZero is also one of the most audited protocols having conducted 20+ formal audits.

For more information about how LayerZero messaging protocols works, refer to their official documentation.

Strategy Mismanagement

Strategy mismanagement represents a risk concerning the management and execution of the various delta-neutral strategies. Effective strategy execution is crucial to ensuring the profitability and stability of the protocol. Operational errors in setting up, configuring, or managing the trades can lead to unprofitability and adversely affect the overall performance of the protocol.

To minimize the risk of strategy mismanagement, Arcana has a team of risk managers dedicated to managing the strategies and executing trades, leveraging automated processes wherever deemed safe and beneficial. Initially, there will be a combination of manual and automated workflows to ensure that the process functions as intended and to validate the effectiveness of the automated systems. Over time we expect a gradual increase in automated tools designed to streamline these processes, making them as smooth, automatic, and error-free as possible.