santipu_ - Funding fee will be inaccurate when leveraged positions are not closed

[sherlock-admin4]

santipu_

high

Funding fee will be inaccurate when leveraged positions are not closed

Summary

With the new changes in the codebase, the global PnL isn't settled until the individual positions are closed or liquidated. This change will cause an inaccurate funding fee when there are some open positions with pending PnL.

Vulnerability Detail

The function that calculates the current funding fee is the following:

https://github.com/sherlock-audit/2024-03-flat-money-fix-review-contest/blob/main/flatcoin-v1/src/FlatcoinVault.sol#L451-L474

   function _getUnrecordedFunding()
        private
        view
        returns (int256 fundingChangeSinceRecomputed, int256 unrecordedFunding)
    {
        int256 proportionalSkew = PerpMath._proportionalSkew({
>>        skew: int256(_globalPositions.sizeOpenedTotal) - int256(stableCollateralTotal),
>>        stableCollateralTotal: stableCollateralTotal
        });

        fundingChangeSinceRecomputed = PerpMath._fundingChangeSinceRecomputed({
            proportionalSkew: proportionalSkew,
            prevFundingModTimestamp: lastRecomputedFundingTimestamp,
            maxFundingVelocity: maxFundingVelocity,
            maxVelocitySkew: maxVelocitySkew
        });

        unrecordedFunding = PerpMath._unrecordedFunding({
            currentFundingRate: fundingChangeSinceRecomputed + lastRecomputedFundingRate,
            prevFundingRate: lastRecomputedFundingRate,
            prevFundingModTimestamp: lastRecomputedFundingTimestamp
        });
    }
}

The first thing the function does is to calculate the proportional skew, and it uses the total size of the traders (sizeOpenedTotal) and the total stable collateral deposited (stableCollateralTotal). The issue is that with the new changes, the global PnL isn't settled when settling funding fees, but it's done when every individual position on the market is closed.

This means that when there are some open positions on the market with pending profits or losses, the value of stableCollateralTotal won't be accurate because it won't take into account the unrealized PnL. This will cause the resulting funding fee will be wrong, and that will imbalance the market, causing a huge mess on the FlatMoney protocol.

The docs define the funding rate as the following:

Borrow Rates (a.k.a., funding rates): To ensure that the price of a perpetual contract stays close to the underlying asset's spot price, funding rates are used. In the Flat Money documentation, we refer to this as the borrow rate. Traders who hold positions that go against the current discrepancy will receive payments, while those on the other side pay. This mechanism encourages traders to close or open positions, which in turn helps align the perpetual contract's price with the spot price.

When the funding is wrongly calculated, the market won't be in equilibrium, and that will undermine the whole "delta-neutral" narrative of the protocol. When UNIT holders (LPs) see that their positions are not delta-neutral as the protocol claims, they'll withdraw their liquidity, causing a loss for the overall protocol.

Impact

When there are open positions with pending PnL, the funding fee will be inaccurate. Given that the funding rate is the core mechanism that the protocol has to balance the LPs and the traders, an inaccurate funding fee will cause an imbalance in the protocol, breaking a core invariant and causing a greatly skewed market.

Code Snippet

https://github.com/sherlock-audit/2024-03-flat-money-fix-review-contest/blob/main/flatcoin-v1/src/FlatcoinVault.sol#L456-L459

Tool used

Manual Review

Recommendation

It's recommended to take into account the global PnL of the leveraged positions when calculating for the funding rate.

[sherlock-admin4]

1 comment(s) were left on this issue during the judging contest.

santipu_ commented:

High

[rashtrakoff]

While it seems logical based on the way the protocol previously handled funding rate calculations, you are misinterpreting the purpose of funding rates. The market is delta neutral even if global pnl is not accounted for like the way we used to earlier or the way you suggest. Let's take an example:

Price $1000/ETH:

stableCollateralTotal = 100 ETH = $100K global size = 100 ETH = $100K global pnl = 0 (assume this is the initial state of the market for simplicity)

Price $2000/ETH:

stableCollateralTotal and global size is still the same but global pnl is now $100K. This means the settled global margin is 150 ETH and the settled stable collateral total is 50 ETH. If you see the values in dollar terms, 50 ETH => $100K. The value of the LPs has been preserved in just the way a delta-neutral position behaves. CC @itsermin

Funding rates only incentivise the market to not be too skewed to any one side. When the market is skewed that's when the above math starts breaking down and the delta-neutral property is not satisfied. Hope this is clear.

[itsermin]

Yes @rashtrakoff is correct, the funding fee is there to reduce skew to 0 (hedge LPs). Eg if you have a hedged market, even after a price change, the funding math still sees a hedged market which is what you want. If the ETH price decreases by 50%, stableCollateralPerShare doubles. The market is hedged and the funding rate does not need to adjust.