Using SMART Alpha

This post was originally published on Barnbridge

Earlier this week, we announced the upcoming launch of SMART Alpha. Today, we’ll be taking a look at the various use cases that will be possible once the application is live.

SMART Alpha Refresher

SMART Alpha creates single-asset pools for any non-rebasing ERC-20 with a Chainlink price feed. It is epoch-based, meaning that you deposit the underlying asset for a set period of time and cannot enter and exit until the subsequent epoch. You enter either as a junior or a senior and receive a [perpetual] ERC-20 proof of liquidity that can then be used further (e.g., junETH, senETH).

When price goes up, seniors give up some of their assets to the juniors, and vice versa. As a result, seniors get absolute downside price protection and juniors get cheap, liquidation-friendly leverage.

SMART Alpha calculates how much downside protection seniors receive and how levered juniors are for a given epoch as a function of junior dominance. Junior dominance is defined as the share of the SMART Alpha pool that is composed of junior-side deposits:

  • When juniors make up a small portion of the pool, seniors receive reduced downside protection while juniors receive greater leverage than what they would at higher dominance levels.
  • When juniors make up a large part of the pool, their leverage relative to the underlying asset is reduced while seniors receive up to a maximum amount of downside protection.

Fees for these positions are only assessed against the performance of the winning side of a given epoch. So, if you’re on the junior side and it winds up being a down epoch, you wouldn’t bear any salt in the wound.

Using SMART Alpha Senior Positions

Senior positions are unique in that they offer a combination of downside protection with upside exposure. This means that at the end of a given epoch, the user is always up in terms of either dollars or underlying asset. Moreover, because the position’s upside exposure is limited and its downside is protected, it will experience low volatility relative to the underlying asset.

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For example, let’s assume that ETH declines 10% from $3,000 over the course of the epoch and that this decline is covered by the senior position’s downside protection:

A SMART Alpha senior position protects the user’s initial deposit during a 10% dip.

Now let’s assume that ETH increases 10% from $3,000 over the course of the epoch and that the senior position is receiving 31% upside participation:

A SMART Alpha senior position gives up a portion of the underlying asset during a 10% price increase.

These possible outcomes should prove to be compelling for a variety of users:

  • Project Treasuries: Senior positions allow teams and DAOs with large holdings of their native asset to hedge downside risk while acting as a liquidity provider for other holders in search of leverage.
  • Collateralized Borrowers: Senior positions with sufficient secondary liquidity could be a source of low-volatility collateral across DeFi lending markets. The BarnBridge DAO will actively look to list these assets on its Rari Fuse pool with competitive loan-to-value ratios in the coming weeks. There could also be opportunity for perpetual swap protocols in particular to utilize senior positions as collateral.
  • Wary Traders: Senior positions provide an alternative to selling an asset when a user anticipates that a local price top has been met in the underlying asset. Should ensuing price drops fall within the absolute downside protection of the senior position, it would be the case that the user avoids losing money in dollar terms while having maintained optionality for partial upside participation.

To get a sense of this last point, consider the following scenario:

A SMART Alpha senior position experiences reduced volatility over a three-week period relative to the underlying asset as described below.

What happened?

  • One user bought 1 ETH and held it, whereas the other bought 1 ETH and deposited it into the senior side of the SMART Alpha Ether pool
  • Epoch 1 took the market by surprise with a 20% drop, meaning there was enough junior liquidity to keep the seniors whole
  • Epoch 2 showcased a bounce of 20%, of which the senior side participated in 31% of for a 6.2% total gain
  • Epoch 3 put in a higher low as it dropped 15%, but this time the market was decidedly more bearish, leaving seniors with protection for only the first 10% and resulting in a 7.6% overall drop for them

We’ll be sharing more about the calculations underpinning the outcomes illustrated above in a blog post next week. In short, the amount of juniors drives how much protection and upside participation is available to seniors, and market sentiment is ultimately what determines the amount of juniors. If that sounds intimidating, don’t sweat it: the user interface for SMART Alpha will have a modeler handy for you to assess the conditions of every upcoming epoch before you deposit.

Using SMART Alpha Junior Positions

Junior positions present a different type of leverage compared to existing solutions in DeFi, and for a longer tail of assets, it may be one of the only forms of leverage available. What junior positions lack in capital efficiency (vs. options) and granularity (vs. perpetual swaps), they make up for with ease of use and and forgiving outcomes.

Consider the following scenarios:

  • Liquidation Protection: The underlying asset drops 15% to begin the epoch, but thanks to our friend the Dalai Lama, it finishes the epoch up 1% on the following Monday. The junior position views the epoch as atomic, meaning that its conclusion was all that mattered.
  • Time Insensitivity*: The underlying asset has just dropped 50% on the eve of an upcoming epoch. Our user signals to enter the next epoch with a junior position and intends to remain in it for an extend period of time, as they view the cycle bottom to be in. The user will pay no funding rate for this junior position, instead just paying a management fee to the protocol whenever an epoch finishes in their favor.
  • Realizing Gains: The underlying asset has started the week off strong with a 25% move to the upside. A junior user who doubts that the performance can be kept up through the end of the week would be able to sell the junior position in a non-fragmented market, given that it’s a fully fungible position.

Like with senior positions, junior users won’t know the exact terms of the epoch until advancement. Our UI will feature predicted leverage for the lead up to epoch advancement to ensure that the user doesn’t enter an epoch with unsuitable terms for their purposes. Moreover, it could facilitate the user making use of multiple applications to achieve their preferred leverage profile, as the SMART Alpha junior would be complementary to other sources throughout DeFi.

*Savvy readers will be quick to point out that you can’t just hide the time element from the equation. We expect it to manifest in the secondary markets for these positions — the further away you are from the next epoch advancement, the greater the discount placed on the position relative to its theoretical claim on underlying assets will be.

On SMART Alpha Pool Upgradability

As you may have noted both in this blog post and in the one on Monday, we keeping alluding to the concept of upgradability. What does this actually mean in practice?

SMART Alpha will ship with a default epoch duration and a default seniorRateModel reference smart contract.

  • Epoch duration answers how long the epoch goes for and when it advances
  • seniorRateModel is the mathematical function that determines what a specific junior dominance level means for both juniors and seniors in a given epoch

The first element is straightforward enough. Modifying epoch duration could be done to minimize the impact specific market periods have upon the opening and closing price of a given epoch. Minimizing the amount of SMART Alpha pools that have synchronized opening and closing times could also help to mitigate gas fees at scale. Certain assets may even benefit from different time horizons: one could imagine hyper-short epochs for stablecoins on Layer 2 deployments of SMART Alpha that capture deviations from the peg.

The second is a bit more technical. Every SMART Alpha pool has a pointer to another smart contract called seniorRateModel. Various versions of the seniorRateModel could be deployed and referenced by any number of pools. Different versions of the model would feature different caps on senior downside protection, as well as varying slopes for how quickly senior protection and upside exposure change with junior dominance. The right to such modification belongs with the BarnBridge DAO, and we should expect that a working group will come to act as a calibrator across these pools in the future.

Why would modification be necessary? It comes down to the fact that SMART Alpha does not exist in a vacuum — there are other ways to hedge and lever assets. This reality manifests itself in the extreme outcomes of the seniorRateModel. While junior dominance ranging between 20% and 80% would be in line with crypto’s penchant for drastic market sentiment shifts, repeat epochs featuring single-digit or in-the-nineties junior dominance could be indicative of either junior or senior positions not being competitive for the amount of hedging or leverage they offer.

Looking Forward to Next Week

We’ll be publishing two more pieces in the lead up to the launch of SMART Alpha. The first will focus on the nature of secondary liquidity for derivative SMART Alpha assets, while the latter will feature backtesting insights with our final default seniorRateModel template. These will be accompanied by the release of our public modeler, which will allow you to play around with an intra-epoch view of the app and get a sense for what you can expect in the live version.

About BarnBridge

BarnBridge is a suite of risk tokenization protocols for DeFi. Its applications allow users to select from opposing pools and take positions on risk factors like interest rates or asset prices. Its first application, SMART Yield, offers fixed and levered variable yields on stablecoins deposited into underlying lending markets like Aave, Compound, and C.R.E.A.M. Finance. Its application suite has expanded to include SMART Exposure, a position rebalancing solution, as well as SMART Alpha soon, which will allow users to calibrate their exposure to price movements in an underlying digital asset. BarnBridge is currently live on Ethereum and the Polygon Network.

Keep up to date with the BarnBridge community via the following channels:


Using SMART Alpha was originally published in BarnBridge on Medium, where people are continuing the conversation by highlighting and responding to this story.

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