MORPHO-ETH Protocol-Owned Liquidity (POL) Strategy

[Gauntlet]

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

@antonttc

• 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?

@prevert

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

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.

@antonttc

3. 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.

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.

@antonttc

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).

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

@SEEDGov

• Since this initiative costs ETH - Does Morpho currently hold the needed amount? If not, what are the alternatives?

@GFXlabs

Is there a particular reason to pair the MORPHO with ETH instead of stable coins?

@SEEDGov

• 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?

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.

@prevert

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?

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.

@SEEDGov

• Will AERA (or Gauntlet) implement any cross-chain arbitrage strategies between Ethereum and Base?

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.

@SEEDGov

• Can you elaborate more on how the rebalancing mechanisms you mentioned work? Is there post-deployment intervention or is it a zero-moment setting?

@SEEDGov

• How does the range configuration will be made?

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.

@SEEDGov

• Regarding “encourage external liquidity, and minimize arbitrage losses” - Could you elaborate more on how this will be implemented?

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.

@GFXlabs

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.

@SEEDGov

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.

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.

@prevert

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.

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.