MORPHO-ETH Protocol-Owned Liquidity (POL) Strategy

Governance
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Overview

In the discussion of the MORPHO token transferability, the community has initiated several conversations concerning DEX liquidity on both Base and Mainnet. This is an area where Aera and the Aera Protocol can contribute our experience and support to the growth of the MORPHO protocol.

We have a proposal for two tranches of liquidity to be deployed via the Aera protocol:

  1. Provide day one liquidity through dynamic concentrated liquidity positions on Uniswap V3
  2. After day one, use the Aera Guardian (run by Gauntlet) for autonomous rebalancing

About Aera

Aera is a solution for optimizing DAO funds autonomously and on-chain. For most DAOs, treasury funds (e.g., reserves, treasuries, safety modules, backstops) are not actively managed or adjusted based on market conditions. For DAOs, this can lead to an inability to maintain a runway, cover liabilities, and benefit from growth in the market. Traditional institutions can allocate funds to more nimble managers who make day-to-day decisions. Still, DAOs face numerous challenges with this model, including governance and creating strong incentive alignment with external managers. Aera was built and incubated by the team at Gauntlet.

  • Aera helps to minimize bureaucracy, freeing a DAO to pick assets and define its objective.
  • The Aera protocol autonomously rebalances liquidity positions based on market conditions.
  • Gauntlet is currently the first Guardian operating on Aera.

Aera has been audited by Spearbit, which can be seen in our docs. Additional modules have been audited by OpenZeppelin. There is an ongoing bug bounty with Immunefi.

How Aera Works

Aera allows DAOs to manage treasury assets effectively in an autonomous, risk-aware manner. Aera has collaborated with other blue-chip DeFi treasuries, like Compound, Moonwell, and Threshold, to onboard their treasuries to Aera.

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Aera provides DAOs with a one-stop, non-custodial solution for managing treasury funds efficiently and transparently. The Aera protocol consists of vaults constructed on a per-protocol basis and can hold a combination of stablecoins, native tokens, and other cryptocurrencies.

Each DAO determines the vault’s highly customizable portfolio strategy. Strategies can range from simply keeping fund proportions in line with liabilities to complex strategies using liquidity positions to provide POL. Vault Guardians automatically rebalance vaults, proposing updates to the portfolio based on the DAO’s desired portfolio strategy.

About Aera Guardians

When an Aera vault is created, the owner specifies a set of guardrails for their treasury. These guardrails include:

  • Assets allowed in the vault (USDC, ETH, etc.)
  • Whitelisted strategies (stablecoin yield, eth yield, protocol-owned liquidity, etc.)
  • Whitelisted DeFi platforms (Uniswap MOPRHO/ETH pool, etc.)
  • Slippage (e.g., max 5% daily slippage or as defined by the DAO)
  • Treasury objective function

The Guardian will then utilize off-chain logic to suggest optimal rebalancing within the confines of the vault guardrails. Guardians cannot suggest transactions that violate the vault’s guardrails, nor can they withdraw the assets from the vault. Gauntlet will be the Guardian of Morpho’s Aera vault for this strategy.

Guardians cannot:

  • Withdraw vault funds
  • Swap into an asset or deploy a strategy outside of vault guardrails
  • Utilize non-whitelisted protocols

The MORPHO-ETH Liquidity Strategy

We propose the following strategy to support both day-one MORPHO-ETH liquidity and a longer-term plan for sustained liquidity.

Creation of the Morpho-ETH Vault

Aera will create a Morpho-ETH Vault to facilitate a dynamic LP position. The Morpho Association will deposit $2.9M worth of MORPHO and ETH. Aera will deploy this capital in Uniswap V3 liquidity positions, on mainnet and base.

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Dynamic POL Management Strategy

Aera achieves higher capital efficiency than traditional POL by using targeted Uniswap V3 positions to backstop significant price moves while returning greater yield to external LPs. Further, Aera introduces dynamic POL management that can account for the expected volatility from day one of MORPHO’s transferability.

Because Aera’s POL ranges are determined by token volatility and pool liquidity, Aera can rebalance Morpho’s POL positions daily to facilitate swaps, encourage external liquidity, and minimize arbitrage losses.

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Once price moves have stabilized (i.e., flows have become more balanced), Aera tightens its POL ranges. Eventually, as Morpho introduces LP incentives, Aera can position Morpho POL using a tiered liquidity strategy outside the fee-generating zone. This modification further facilitates the attraction of external liquidity to the pool, improving external LP returns by lowering price volatility while not cannibalizing external LP yield from fees.

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Determining Liquidity Targets with Gauntlet

To reach its recommended liquidity targets, Gauntlet used data from comparable lending protocol tokens to estimate a target for an initial allocation to calculate the day-one POL requirements. The analysis targeted three variables:

  • The initial estimate for annualized volatility is 0.8. This is based on comparable token volatilities and calculated against ETH.
  • Slippage targets were calculated for each tranche of liquidity:
    • Target 5% of DEX volume within 1% slippage for the first tranche of liquidity
    • Target 15% of DEX volume with 1% slippage in the second tranche of liquidity
      • This is set on the lower end to reduce exposure to LVR.
  • Assume DEX volume (relative to market cap) is similar to comparable tokens, except for Base token volume, which will primarily go through DEXs.

We can visually represent the resulting LP positions. These are the positions on day 1 for mainnet, which would subsequently be rebalanced daily around the market price.

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Potential Risks and Challenges

What is the Cost of POL?

Loss Versus Rebalancing (LVR) is the primary cost for the POL strategy. LVR depends on volatility; empirical models can estimate this cost (see here). These costs are offset by fee yield, which depends on volume.

Next Steps

We look forward to hearing from the community on the above POL strategy and Morpho’s liquidity plans to support token transferability. Gauntlet and Aera will deliver the outlined strategy at no cost.

Moving forward, we aim to explore ways to supplement this initial POL allocation with expanded LM programs for both Base and Ethereum mainnet to support a sustainable long-term liquidity strategy.

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I would love to see usage of such an on-chain framework for POL strategy. However, I would appreciate some clarification on the following points:

  1. According to the docs, a Chainlink-compliant MORPHO oracle is needed for Aera Fee. Is the fee planned to be charged from day one? If yes, which oracle will it be using?

  2. According to the audit report, there are quite a few trust assumptions we’re putting on this Guardian role. A few quotes from the report:

  • Issue 5.2.1: The Guardian can use their own MEV opportunities

  • Issue 5.2.4: Guardian can rapidly drain 2 * maxDailyExecutionLoss (%) * vaultValue

  • Issue 5.2.6: Guardians can artificially increase accrued fee for free (context: If they have been given ability to transfer the token out of a vault), which is harder to detec.

While we can assume Gauntlet has no incentive to act maliciously, I would like to see a process set up for the community to verify the behavior of any guardian to minimize these concerns. I wonder if Aera has already implemented any of these measures for other protocols (I couldn’t find any with a quick search).

  1. Are there any reports from the Aera team that summarize the results of such POL strategy with Aera vaults? It seems that among the links above, only Compound and Moonwell have actually been using Aera, and they were both used for treasury management, which is quite different from LP management.

With these concerns in mind, I still strongly support such an on-chain framework to actively manage POL, this is a great proposal.

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Thanks for this interesting proposition. A few thoughts to prolong the discussion.

I’m in favor of a POL strategy for Morpho and the AERA solution could be a great fit. I think we have to keep in mind that this is an alternative solution to a full LM program which should be reduced accordingly.

Setting the width of the price range can be optimised by statistical methods and I tend to trust the Aera team to do this efficiently. At the same time, I browsed the documentation and didn’t find concrete information about the kind of rebalancing strategies implemented. Is it basically resetting the price range so that the market price stays closed to the mid price?

Active management on top of Uniswap V3 pools is notoriously difficult. Implementing POL from day one is even more difficult due to the uncertainty about the price interval. I would personally wait a few days or weeks before setting the price range. The price range indicated in the diagram is 0.12 - 2.9. I’m curious if it’s for illustrative purpose only or the actual range that Aera plans to implement.

There is no mention of the risk of impermanent loss. This risk can be managed to some extent by frequently rebalancing the pool but this comes with its own costs due to a form of volatility decay (basically buying high and selling low). I think this risk should be discussed as well.

As @antonttc I would like to know if this type of strategy has been used in the past and what were its profitability.

Last, there is no information provided about the fee structure.

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Hey @Gauntlet - It’s a good initiative to start the debate about the use of POL; appreciate it!
Here are some concerns that come up during the lecture

  1. Since this initiative costs ETH - Does Morpho currently hold the needed amount? If not, what are the alternatives?
  2. Can you elaborate more on how the rebalancing mechanisms you mentioned work? Is there post-deployment intervention or is it a zero-moment setting?
  3. How will the liquidity pool bootstrapping be designed?
  4. How does the range configuration will be made?
  5. Given that crypto asset volatility is more dependent on current market conditions rather than similar assets’ behavior in different periods; How you will predict volatility especially during the launch phase?
  6. Will AERA (or Gauntlet) implement any cross-chain arbitrage strategies between Ethereum and Base?
  7. Regarding “encourage external liquidity, and minimize arbitrage losses” - Could you elaborate more on how this will be implemented?
  8. Can you define what type of controls, decisions or interventions the suggested alternative requires from AERA?
  9. “These costs are offset by fee yield, which depends on volume.” - While assuming that fees will always exceed LVR and IL may not always be the case; it’s not mentioned, but POL management also brings necessary treasury diversification for the DAO.
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Is there a particular reason to pair the MORPHO with ETH instead of stable coins?

Also, if the goal is to provide liquidity for MORPHO, and in a way that minimizes cost structure and risks, why not just do a Uniswap V2 pool with MORPHO-stablecoin? Then governance is removed from most trust assumptions, and is strictly “set and forget”. It’s not the most efficient way to do POL, but it’s probably the cheapest and safest while serving the mandate of providing onchain liquidity for MORPHO.

Note that this strategy has worked very well for MakerDAO, and it has the benefit of also acting as a buyback program in down markets. Simple, safe, free, and “pretty good” seems like the best place to start. It also prevents the management of it being distracting for governance. Morpho is a software protocol, not a hedge fund, so it doesn’t make a ton of sense to engage in active investment strategies.

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Pairing to ETH compared to a stablecoin has the advantage of minimizing divergence risk and impermanent loss. A Uniswap V2 solution seems a bit backward but I agree it would be consistent with Morpho as an infra without too much third-party dependency.

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Generally in favour of building PoL as it will enable Morpho to eventually have a set and forget strategy. Short and medium term, especially at TGE, active management can be extremely profitable for fees, and it is a great timing for a Morpho aligned entity to accumulate PoL.
However long term, having a full range pool will simply be more efficient once enough data will have been collected and it is possible to tweak it correctly. This is especially true as there is simply no way for anyone to prevent the PoL to be drained in one buy/sell order (illiquidity is the real risk, not LVR).

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Thanks to @antonttc, @prevert, @GFXlabs, and @SEEDGov for the thoughtful analysis and questions. We’ve responded directly to the comments below, but here are a few high-level responses to these questions:

  • Neither Gauntlet nor Aera will charge fees on this POL strategy or the Aera Vault.
  • Two funding avenues exist for this proposal, with the first likely being preferable to support both sides of the market from day one:
    • The Morpho Association could deposit the ETH and MORPHO required to execute this strategy.
    • Alternatively, the DAO could provide MORPHO, which could be made available as single-sided liquidity and rebalanced as swaps occur.
  • This POL strategy aims to execute a capital-efficient strategy to reduce slippage conditions. In the future, the DAO could deploy a new objective function focused on yield generation or treasury diversification. However, introducing a new objective function would introduce a different execution strategy for POL than described in this proposal.
    • The anticipated cost to maintain the strategy is approximately 4% annually, calculated in loss-versus rebalancing (LVR).
    • This strategy uses ETH as the paired token because it reduces pool price volatility and minimizes LVR costs, enhancing capital efficiency.
    • Uniswap V3 enables more capital-efficient liquidity because it allows liquidity managers to meet slippage conditions without providing additional capital in ‘tail liquidity,’ which would be required in V2.
  • Aera has built-in guardrails to ensure the Guardian cannot withdraw funds or engage in unauthorized activities. This is enforced at the smart contract level. Aera is non-custodial, and all operations are fully on-chain, allowing any community member to observe the Morpho-ETH POL strategy on the Aera App anytime.

The Aera Protocol

Gauntlet nor Aera are charging fees for this proposal.

Aera v2 requires an oracle that conforms to the Chainlink smart contract interface. The oracle values the vault’s holdings, which informs various mechanisms, such as constraining guardian actions and calculating fees, but fees do not apply in this case. Gauntlet will deploy a compatible Uniswap TWAP oracle if no external oracle is available. This strategy has been previously used to support tokens such as SEAM, BTRST, and XAI, which lacked oracles at the time of vault deployment.

Four Aera Vaults are actively running LP management strategies. Three are owned by an investment advisor targeting profit and specific ranges. One is a POL strategy for a protocol with the explicit goal of diversifying liquidity across pools. You can read more about POL using Aera here.

The Aera vault will be configured to give guardian-only rebalancing rights essential for strategy execution. The following policies will further constrain guardian permissions:

  • Guardians are limited to actions whitelisted by the vault owner—in this case, the Morpho Association. The Morpho Association can restrict actions to rebalancing transactions only.
  • Each operation is additionally guarded by a slippage bound. This is necessary to allow for essential slippage in actions like AMM swaps without giving the guardian the ability to drain the vault. While we use a relayer to avoid MEV, we are transparent about the possibility of sandwich attacks, although they would be immediately auditable onchain
  • The guardian is also prevented from leaving outstanding token approvals
  • The ability for a guardian to take any actions can be paused at any time both by the vault owner (Morpho) and Gauntlet
  • Offchain, each guardian action is pre-simulated and checked against offchain prices and liquidity.

In short, while we have to be transparent about the possibility of execution slippage in any multi-token strategy, this suite of protections is significantly more restrictive than what is typically applied in the context of individual multisig or governance actions in treasury management.

All Guardian actions and the state of vault holdings are available on the Aera application.

MORPHO-ETH POL

The Morpho Association could deposit the ETH and MORPHO required to execute this strategy. Alternatively, the DAO could provide MORPHO, which could be made available as single-sided liquidity and rebalanced as swaps occur. The first option is likely preferable to support both sides of the market from day one.

Using ETH as the paired token allows Gauntlet to normalize broad market crypto volatility and estimate the initial volatility conditions relative to ETH. We estimate the initial volatility conditions using comparisons to protocol tokens of similar size and function.

ETH was chosen as a correlated asset to reduce pool price volatility, which helps reduce LVR. Pool price volatility directly contributes to the cost of LVR. For a deeper explanation, refer to this video.

When comparing V2 and V3, it’s helpful to consider the proposed POL position as a more capital-efficient version of a V2 position. Supporting similar slippage conditions in V2 would require far more capital for liquidity in price ranges that are unlikely to be reached. With this strategy, there’s no need for tail liquidity, and the position resets daily based on market price. The strategy consults prices across several venues, including CEXes, to determine a fair market price. This further helps reduce losses from adverse selection.

The target slippage for target volume determines the size and width of LP ranges. The price range is reset daily to maintain the slippage conditions around the midpoint price, and reserve liquidity stays far from the midpoint.

Referencing the above response, one can again view this strategy as a more capital-efficient V2 position that does not require providing unused ‘tail liquidity.’ To achieve the same slippage conditions with V2 would require significantly more capital, some of which would never be utilized.

The POL strategy runs independently on each chain, and tokens are not bridged between chains. They will share a common pricing source so as not to be adversely affected by arbitrage but will not actively participate in closing arbitrage.

The POL strategy will occur over a few stages:

  • The initial range will be configured to target slippage conditions around the market price (as described in the post).
  • Gauntlet will observe volatility post-transferability and deploy the POL strategy with initial ranges.
  • The strategy rebalances positions around a market price daily by consulting several sources, including CEXes, to determine a reasonable market price.
  • Over time, if volatility is lower than anticipated, we will tighten the ranges.
  • As more external liquidity enters the market, we will add a spread to avoid taking fees from external LPs.
  • The ultimate goal is to achieve self-sufficient liquidity.

Arbitrage losses result from a pool price being different from other exchanges. Gauntlet’s POL strategy reduces exposure to arbitrage by using rebalances, which proactively adjust liquidity positions toward the market price on other exchanges. This rebalance closes the gap between POL positions and external prices, lowering the margin for arbitrage losses.

Once external liquidity enters the pool, we can avoid putting liquidity close to the pool price so that fees go to the external LPs instead of the POL strategy while still providing liquidity when significant price moves occur. The long-term goal is to bootstrap liquidity and allow the market to be self-sufficient by allowing LPs to earn more.

This strategy aims to achieve target slippage conditions. Its objective is not to generate yield, diversify, buy back, or engage in active investment strategies. While POL is sometimes used for these purposes, in this case, the objective is to target slippage conditions in a capital-efficient manner. As such, the strategy was designed for that specific objective function and utilizes Uniswap V3 to leverage the capital efficiency benefits we outlined previously.

The risk of impermanent loss and LVR is the cost of running a POL strategy that targets slippage conditions. In the same way, incentives are a cost of running a liquidity mining program. However, in the case of POL, a portion of the LVR cost is offset by fee generation. In scenarios where volume is much higher (or volatility is lower than estimated), the POL strategy can generate meaningful yield. This is more likely the case on Base, where POL will likely be the only source of liquidity.

Gauntlet actively calculates and monitors metrics for LVR on liquidity positions and uses an internal model to estimate the LVR cost to target the slippage conditions described.

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Perhaps it’s best to pause this discussion until we actually see what the slippage is on MORPHO once it’s available to trade and some price discovery occurs. There’s not much sense worrying about a solution to a problem that may or may not actually materialize.

Alternatively, we could define now what rate of slippage should be targeted. And if the market doesn’t provide the desired depth on its own, then a competitive process where many solutions can be compared side by side would be a straightforward and interesting task for governance to take on.

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We support the POL (Protocol-Owned Liquidity) strategy for several reasons.

  • Securing initial liquidity is a critical challenge, and this strategy effectively addresses it.
  • The cost to the protocol is less than that of a liquidity incentive program, making it a more efficient option.
  • As @Gauntlet mentioned in their response, pairing with ETH to establish a Uni v3 pool is a reasonable and practical approach.

Regarding @GFXlabs’s comments, while we understand their concerns, we believe it is essential to discuss this proposal and decide on a concrete direction. The token launch presents an effective opportunity to bootstrap initial liquidity, as it naturally attracts attention and higher trading volumes. By gathering sufficient liquidity from the outset, it can be sustained more easily over time. Conversely, if the initial liquidity is significantly lacking, Morpho would have to start by recovering it, which raises concerns about needing to implement additional bold measures. Compared to liquidity mining, the cost borne by the protocol is relatively small, making this a risk Morpho should be willing to accept.

We would also like to raise some additional questions and suggestions.
First, what is the current status of the Morpho Association’s assets? Even if this contribution is not considered a direct cost, we should understand the scale it represents for the entire DAO. As of the end of June this year, 125 million MORPHO tokens were under the association’s management, and although there were reports of fundraising, we do not know the actual holdings in terms of USD, ETH, and MORPHO that they currently possess.

We believe it is advisable to establish a review cycle for this strategy, such as every three months. This would serve as a mitigation against the concerns regarding the partial trust in the Guardian and seems reasonable as a review period that includes considering other approaches.

The discussion on liquidity mining should be designed to build upon this proposal once it has been finalized, with an awareness of synergy. We feel it is meaningful to share this here as well as in this thread. Both strategies aim to deepen liquidity. As Gauntlet’s comment suggests, it seems appropriate to start with the POL strategy and begin a liquidity incentive program at a timing when appropriate effects can be expected. Therefore, it is important to consider how Morpho can maximize liquidity while leveraging the POL strategy decided here.

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Thanks @Gauntlet for your comprehensive answers. I would like to add one comment and one suggestion:

  • The POL strategy will possibly be a net cost for the protocol in the sense that rebalancing and LVR costs may outsize trading fees. For the costs associated with daily rebalancing, see Atis post (see also volatility decay in tradfi), which basically transforms IL into permanent losses. In this sense it is a substitute to a LM program. It’s also a partial substitute in terms of reduction of price impact.
  • Added to a LM program, there is the risk that Morpho pays twice and overpays for the service of liquidity. This is why, a joint analysis of POL and the LM program would be a cost effective approach. Ideally, we should delay the vote for POL until a post about the size of the LM program is discussed in this forum and a joint consensus emerges.
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One point of useful data to consider – based on my research into the topic, the anticipated ~4% annual LVR loss in the Aera vault is substantially more cost effective than public liquidity mining campaigns. If we look at active Uniswap v3 liquidity mining campaigns on Merkl, we can observe that many pools have yields in the neighborhood of 20%.

Therefore, it seems to me that it would make sense for the size of the public liquidity incentives to be determined based on how much additional liquidity the DAO deems necessary on top of the Aera vault. There’s a good chance that the Aera vault model will offer a better performance for the DAO in the long term, but a combination of the two approaches seems like a good idea while liquidity is first being bootstrapped.

I’m in favor of Tane’s suggestion of a quarterly review of this program, which would allow the DAO to observe results and make requests for strategy adjustments without too much overhead.

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Thank you for your responses. If I understand correctly, this initiative would be applicable once MORPHO has on-chain liquidity and/or is listed on CEXs, right? This means it wouldn’t serve as the main liquidity pool for the token but would instead address secondary liquidity issues.

Do you think it makes sense to divert resources toward AERA at this stage, rather than focusing on a primary liquidity pool that meets MORPHO’s initial needs? I’m not saying that addressing slippage isn’t important, but fragmenting resources solely for this purpose doesn’t seem like the best idea, especially at this early stage for the token.

Liquidity for MORPHO, as well as POL, are aspects we should be prioritizing now, regardless of whether AERA is used in the future or not.

Opting for multiple pools introduces several additional challenges:

  • Increased intervention from arbitrage
  • Higher costs to maintain depth across each pool (whether through incentives, with their respective dilution, or via active management)
  • Greater LVR and IL due to fragmented liquidity and arbitrage gaps
  • All of these costs are tied to liquidity depth, which becomes more limited as liquidity is fragmented
  • More dependency, intervention, and decision-making requirements

From this perspective, taking on these costs doesn’t make a lot of sense at least in the initial phases.

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I believe this should be viewed as the primary DEX liquidity pool, the current state of discussion in the public incentives thread is that incentivizing DEX liquidity is likely to be quite costly in the early stages, and that it makes sense to assess needs after a few weeks of transferability before setting a program budget (which, at least on mainnet, would use Uniswap, same as Aera does).

Voting is live now on Snapshot.

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I still think deploying liquidity from day one could be very risky for the protocol. This point has not been enough discussed imho.

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I believe that it’s important to have support for liquidity around the transferability event despite the risks, and that it’s worth proceeding with the best readily available strategy given that the transferability vote is already in progress. The vault strategy does mitigate the LVR risk to a significant extent – as you can see from the chart posted by Gauntlet, only ~$400k is in a tight range, and even if this needed to be rebalanced, the cost would be reasonable compared to the 20%+ annual cost of public liquidity incentives.

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