Canto strides to advance as a forward-thinking entity, moving beyond the standard norms of L2s and conventional DeFi to focus on the integration of Real-World Assets (RWAs). The collaboration between Canto and Polygon Labs focuses to accelerate the RWA movement. . Through this alliance, Canto claims to make a marked entry into the burgeoning domain of 'NeoFinance,' promoting a surge of application-layer around RWAs. In a setting where RWAs and blockchain technology converge to alter financial frameworks, can this alliance really serve as a conduit between traditional assets and DeFi? This report endeavors to probe further into such assertions to ascertain the truth.

In this report, we will examine the evolution in Canto’s infrastructure (from v1 to v2), explore its assertions regarding NeoFinance, review Canto's Ecosystem roadmap, analyze its unit of account token, and investigate the overall risks.

Canto V1 and V2:

Canto 1.0:

Canto 1.0 aimed to propel the DeFi movement further, focusing on transparency, decentralization, and open accessibility. It utilized Tendermint consensus secured by Canto validator nodes and featured an EVM execution layer via Cosmos SDK. The integration of Cosmos SDK facilitated the creation of multi-asset public PoS blockchains, aligning with the objective of promoting a Free Public Infrastructure (FPI).

1.0’s Pros:

• Permissionless nature enables open participation and innovation.

• Utilization of Cosmos SDK allows for the creation and integration of custom blockchains, promoting flexibility and interoperability.

• Contract Secured revenue - read more here 

1.0’s Cons and Limitations:

• Limited to the functionalities and capabilities of the Ethereum Virtual Machine (EVM).

• Potentially less efficient and scalable compared to Layer 2 solutions.

• Lack of deeper liquidity limiting confidence - mainly stemming from the fact that it was not Ethereum secured.

Canto 2.0:

With a forward-looking vision, Canto transitioned into Canto 2.0, partnering with Polygon Labs to establish a ZK Layer 2 on Ethereum aimed at real-world asset integration. Canto 2.0's establishing an entire new category called NeoFinance is one to pay close attention to. The migration to a ZK chain with the help of Polygon Chain Development Kit (CDK) not only retains the core principles of permissionless sovereignty but also amplifies liquidity and user security through the best ZK prover rooted in Ethereum's cryptographic security.

NeoFinance:

For NeoFinance to effectively expand on a larger scale, it requires a substantial liquidity pool while ensuring security, embodying a scenario where trustlessness and decentralization are predominant. Can Polygon CDK help facilitate such a scenario?

Polygon Labs in their Polygon 2.0 paper presents a solution where all the app chains built using the CDK shall converge onto a common aggregation layer to establish atomic cross-chain communication, share liquidity and other resources. Utilizing the tools provided by this development kit, Canto aims to become the L2 for all things RWAs just like IMX (the go to gaming chain for Polygon). The concept of fluid interoperability of ZK L2s, while maintaining independence and modularity, is a unique offering from Polygon Labs, and Canto acknowledges the potential by accepting this idea.

2.0’s Pros:

• Migration to a ZK L2 enhances scalability and lowers transaction costs.

• Plonky2 ZK proving implementation alongside a PoS validator set ensures decentralized sequencing (in the future), elevating trustless guarantees.

• Seamless interoperability with the larger Polygon ecosystem facilitates increased liquidity and cross-chain communication without the need for risky bridges.

2.0’s Cons and Limitations:

• Dependence on Polygon CDK and Ethereum’s infrastructure could potentially introduce external vulnerabilities or dependencies.

• Integration of real-world assets might face regulatory hurdles and practical challenges, slowing down the envisioned NeoFinance revolution.

What do the big boys think about RWAs?

The healthy market cap of Polygon and strategic institutional partnerships with huge Traditional Finance banks like Franklin Templeton and Hamilton Lane depict robust institutional acceptance. This alliance seems to embolden Canto's position in the ecosystem, aligning with the burgeoning trend of asset tokenization as revealed by the BNY Mellon Report.

Evaluating the Roadmap and Value Propositions

An Attempt Towards Building a Thriving Ecosystem

Canto, with its emphasis on Real World Assets, has developed an entire ecosystem of new primitives including Canto DEX, Canto Lending Market (CLM), and the $NOTE unit of account. Canto DEX is designed to be a platform for liquidity providers, offering zero-fee trades. CLM serves as a marketplace to facilitate borrowing and lending, aiming to mirror the ease of traditional financial transactions. $NOTE is described as a fully collateralized, decentralized, and automated unit of account token.

NOTE and The Secrets of Burgeoning Yield on RWAs

$NOTE

The $NOTE is a fully collateralized unit of account token within Canto's ecosystem. Its algorithmic construction has provisions for maintaining price stability, aiming for a balanced, capital-efficient, and automated financial model.

The backing by other stablecoins like USDC and USDT provides a level of protection against depegging risks, which can contribute to the reliability and stability of the Canto chain. Its price stability is overseen by an accountant contract, which adjusts interest rates to strive for balance and ensure proper management of the counterparty risks in $NOTE.

The Opportunity to Carry Trade on RWAs

Although RWAs provide investors with very small interest rates annually, users on Canto can take a leveraged opportunity to earn multiples. This can be made possible through a  mechanism known as the Carry Trade which involves the following steps:

1. Systematic compliance onboarding with the RWA issuer, ensuring that the necessary legal and procedural bases are covered.

2. Following the compliance onboarding, investors then proceed to mint RWA Tokens. These tokens essentially represent a traditional financial instrument – for ex. Treasury Bills – on the CANTO L2.

3. Once the T-Bill RWA Tokens are minted, they are posted as collateral on the Canto Lending Market, an innovative platform that interfaces real-world assets with decentralized lending. This action is crucial as it underpins the borrowing capacity of the investor within the decentralized finance ecosystem of Canto.

4. With the collateral in place, investors will be able to borrow NOTE, a decentralized stablecoin, against their T-Bill RWA Tokens.

5. Having borrowed the NOTE, investors proceed to sell the NOTE for USDC, thereby completing the loop of the Carry Trade.

The math underpinning the expected returns is compelling. With a t-bill rate of 5.5%, a NOTE rate of 5.15%, and a mere t-bill margin requirement of 1%, the carry trade seems structured for optimal return. Assuming assets worth $1M are deployed, with a debt amounting to $990K, the position value stands at $10K. This arrangement leverages the APR to 35%, a figure that significantly outstrips conventional returns in traditional financial markets.

veRWAs and Enhanced Yield

On the financial yield aspect, there's an anticipated target of 10-15% annual percentage yield (APY) on cNOTE, enhanced with additional Canto incentives, which will be subjected to a governance vote.

Post-approval, Canto plans to introduce T-bills as collateral markets to the Canto lending market. Following this, the launch of the veRWA primitive, entailing CANTO subsidies, is on the horizon.

This veRWA launch, inspired by the veTokenomics of Curve protocol, will coincide with the initiation of the first independent lending market accepting other RWAs as collateral. The integration of veRWA primitive is poised to boost the Annual Percentage Rate (APR) on cNOTE deposits.

Depegging Risks

One notable risk for the counterparty, particularly the asset issuer or the borrower of $NOTE, is a major depeg, coupled with risks associated with the vulnerability of the Canto chain. In the context of $NOTE depeg, being an over-collateralized algorithmic stablecoin, it can only be borrowed against tBills. Therefore, a depeg situation could only arise in instances of an exploit or if the tBills are not redeemable instantly (or extended duration risk).

An interesting way to incentivize stablecoin depth on Concentrated liquidity pools is liquidity mining on specific ranges chosen by issuer (or later on community).

Conclusion

The collaboration between Canto and Polygon Labs ventures into NeoFinance is one we will be closely monitoring. Moving from Canto 1.0 to 2.0 aims to improve scalability, liquidity, and security, though it potentially introduces external vulnerabilities.

How does HL work?

The main vault i.e. HLP on the Hyper Liquid market operates via an orderbook, which is protocols vault that provides liquidity. Users have the ability to create their own vaults to execute their strategies and attract liquidity to their vault.

It is important to note that it may not always function as the counterparty for all participants, depending on the liquidity dynamics within the platform.

The HyperLiquid L1 state encompasses all margin and matching engine states. It is worth noting that Hyperliquid does not depend on off-chain order books. A fundamental design principle is complete decentralization, achieved through Tendermint consensus, which ensures a consistent order of transactions and is optimized for end-to-end latency. HLP vault is the in house market maker vault for platform, helping build strong orderbook.

For an order placed from a geographically co-located client, end-to-end latency has a median 0.2 seconds and 99th percentile 0.9 seconds.

The validators are responsible for publishing spot oracle prices for each asset every 3 seconds. The oracle prices are used to compute funding rates. They are also a component in the mark price which is used for margining, liquidations, and triggering TP/SL orders.

The spot oracle prices are computed by each validator as the weighted median of Binance, OKX, Kraken, and Huobi spot prices for each asset, with weights 3, 2, 2, 1 respectively. Oracle price is used for computation of funding rate & mark price.

Mark price= Oracle price + 5 minute EMA of difference between -(Hyperliquid's mid price and the oracle price). This means for accurate mark pricing it must have robust orderbook. This is particularly useful during periods of high volatility when oracle prices begin to lag and result in significant liquidations.

DYDX uses oracle prices for liquidations and TP/SL which tend to lag in the periods of high volatility.

Risks

• Infrastructure risks-
  As much as it is luring to airdrop farm in size here or trade all your shekels on HL, its prudent to list down and understand all the risks associated with their setup currently.
  *-> Bridge risk *
  currently it’s a closed source bridge with no public 3rd party audit. But upon a long discussion with the team over ☕️ at Token2049 they ensured us they will be soon publishing 3rd party audits and making the source code public. Plus will some [redacted] magic have more security and decentralization. 😉 Thats great news… and makes us hopeful this project helps accommodate size.
  -> Validator risks
  as of today the HL product is quite centralized with 4 nodes and all of them run by the core team. Since HL uses tendermint consensus which can easily scale up to 100 validator nodes (like Polygon PoS) or become a validium (using Polygon CDK) where you don’t have to worry about security bcoz its Ethereum dawg !! I am sure the team (they confirmed) is building actively to decentralize over time with incentivized testnets and more.
  -> HLP risks - There is smart contract risk relating to HLP pool. Other being HLP strategy losing in trending markets. Although all the trades & TVL can be easily verified on-chain.
  → FTX-Alameda risk - Some users speculate that HLP may be able to frontrun the user trades. However since all trades are publicly available on-chain, one can validate they are not doing so. While we haven’t done this so far, we invite the community to run tests here.

Platform Risk-
Hyperliquid has some “special” features that are positive for solvency for HLP and Hyperliquid.

• If Auto deleverage is triggered then traders with negative margin will be settled against most profitable trader. In simpler terms, if it comes down to solvency for platform bad debts will be settled from most profitable traders with leverage.
  
  Below is a conversation with the founders that sheds light on this crucial aspect:

"If Auto deleverage is triggered then traders with negative margin will be settled against the most profitable trader. In simpler terms, if it comes down to solvency for the platform, bad debts will be settled from the most profitable traders with leverage."

     When asked to clarify this process, the founders provided the following response:

"Yes, that is correct. When ADL happens, the bad debt is passed onto profitable traders on the other side. This is how ADL works on CEXs too, and it's a last resort measure that has never yet triggered on HyperLiquid."

• In case of liquidation maintenance margin is not returned which is very high for volatile coins. So keep SL to protect against liquidations and preserve maintenance margin.

Summary

All in all we love the product and have been actively trading on it for the past few months. We felt it’s our responsibility to outline the risks involved and thus a part 2 was necessary.
Good for scalping, not yet safe to move size in.

Disclosure - click here to learn more about 3poch’s Hyperliquid disclosure.

HyperLiquid stands out as a cutting-edge perpetual futures decentralized exchange, redefining how traders experience the crypto market. It operates on custom-built blockchain powered by Tendermint consensus, ensuring lightning-fast execution of every order, cancellations, and liquidations, all on-chain, with block latency clocking in at less than one second.

Hyper Liquid L1 currently claims to handle over 20,000 orders per second, offering traders an unparalleled level of performance. What sets them apart is the fusion of GMX Pools and DYDX, creating a seamless blend that brings forth transparency, reliability in execution, and an ever-present pool of user liquidity.

Metrics

Over the past few months (post the launch of onchain tokens like RLB, UNIBOT and BITCOIN) and exclusive trading markets for Friend Tech index, LZ. Hyperliquid has been a CT darling. All Time volumes of HL stand at $4.7 Billion, which is pretty cool in such a short time. In the same time, TVL for exchange is at ATH - $8.6M.

In last 3 months, HLP ( Liquidator and MM for exchange) has generated $802k in profits. It might not sound a lot in absolute terms but generating 800k PnL on just $8 million pool in 3 months with around 10k users.

HyperValue Proposition

You might know them as the exchange with FriendTech perps, but it’s more than just that. It comes with an on-chain orderbook system which has capacity for 20k orders per second, and you can be the house by providing liquidity to the HLP vault (main market maker for exchange).

HyperLiquid allows users to open their vaults and run their strategies and anyone can deposit in 3rd party vaults. This makes HL orderbook comparatively decentralized as anyone can market make.

Liquidations

Liquidations on the platform are efficiently managed by the Liquidator, which is an effective strategy for generating profits for HLP. If a user's position falls below the maintenance margin, which can range from 1% to 16.7% depending on the asset, the liquidation function is triggered. The entire margin will be transferred to the liquidator and will not be refunded.

Yes, maintenance margin will not be returned. If position is isolated then only isolated margin is transferred. Other positions remain untouched. This is done to ensure that liquidations on platform are profitable on average.

After crazy liquidations on YGG last month when oracle prices were 50% higher than actual perp prices, they moved from using oracle price for liquidations as to mark price. Whereas DYDX still uses oracle price.

Fees

Taker fees- flat 2.5 bp (which is about standard)

Maker rebates- 0.2 bps

Referrers receive 10% of their referees' taker fees (0.25 bps)

Out of all the fees collected, 40% is distributed to the Insurance fund and OI rewards each and remaining 20% goes to HLP.

Execution

Mark price is used for TP/SL and limit orders. Slippage on TP/SL orders is increased from 2.5% to 10% because of complaints from community of unfilled TP/SL orders in periods of increased volatility.

Funding rates

Funding computation done by hyperliquid is almost as same as Binance so there is not much deviation in funding rates.

Funding Rate (F) = Average Premium Index (P) + clamp (interest rate - Premium Index (P), -0.0003, 0.0003) Max funding rate is capped at 4%/hour

So what can you do with it TODAY ?

1. Collect Open Interest rewards i.e. 40% of the fees (2x more than what goes to HLP). Every token gets equal allocation, the best ROI is to open a position on a token with very low OI. Doing that you get a higher % of allocation compared to position size. For example- If BTC has 100k open interest and you have a position with 10k worth OI you’ll receive equal interest If you open a position with 1K OI where total OI is just $10k.

2. Farm for potential Airdrop by taking delta neutral positions, using some other exchange for opposite positions. Best strategy - Take a long position on Hyperliquid and a short position on Vertex of equal size in order to achieve delta neutrality. This will allow you to participate in both airdrops at the same time, achieving two goals with one action.

3. Take position on pre launch coins (hyperps) and on chain coins. Save yourself from BUY/SELL tax, gas and overall bad experience of dex trading. This can be bearish thesis for all the TG bots which help in dex trading, and this became quite evident last week when perp volume on $banana was almost 2.5 times the spot.

4. Create your own vault and run your own strategy. Vault leaders receive a 10% profit share for managing the vault. Vaults can be a great way for a trader to share strategies with his or her community.

5. Plain Vanilla deposit in HLP and reap rewards.

In a sea of cheap GMX and Gains Trade forks, it is refreshing to use a CLOB exchange with an interesting architecture. Thank you for reading. We will be publishing a part 2 to detail out the risks associated with Hyperliquid and potential ways to mitigate them.

Disclosure - click here to learn more about 3poch’s Hyperliquid disclosure.