This proposal was put together before the Indigo team announced their plans today that have been in the works for an interest mechanism. It is my take on applying interest to open CDPs, so it would be good to see the team and the DAOs response as well as to understand what the similarities and differences are between my implementation and theirs. This is very much still a skeleton draft and many details need to be nailed down. As such, this post might see a number of modifications as details are clarified.
This proposal is to enact a variable interest rate on open CDPs which is determined by the market price of an iAsset relative to its peg. This interest rate would be 0% when iAssets trade at or above peg and would increase as the market price extends below the peg. This interest functions as an added incentive for CDP owners to scale back or close their positions when the iAssets they’ve minted trade below peg.
This is the core of the proposal, of which many adaptations could stem. Details and nuances of a specific implementation are identified after the Background.
The recent turn in sentiment within crypto and the run up of ADA from $0.23 to $0.45 has resulted in the prominent use of minting or borrowing iUSD and shorting it as a method of leveraging one’s ADA position. The result has led to a substantially reduced iUSD price on decentralized exchanges (DEX) from its peg of $1 for a prolonged period of nearly 3 months to date. A recent proposal was passed to increase the minimum collateralization ratio (MCR) of iUSD from 120% to 150% in an attempt to slow down the supply of newly minted iUSD in hopes that it would result in a reversal of the iUSD price towards its peg.
The initial result appears to have been largely successful in halting the minting of new iUSD, however, it appears that users are still using lending platforms to short iUSD and leverage their ADA positions, so the iUSD price on DEX has remained volatile in a range between $0.82 and $0.94. Such drastic deviations from peg are problematic for iAssets if they are to be treated by others and other protocols as “stablecoins” as it hampers their adoption and utility as such within the ecosystem.
The DAO has also recently approved a redemption mechanism where, once implemented, users will have the ability to redeem ADA collateral for iUSD at a $0.97 equivalent value from CDP owners with the lowest collateralization ratios (CR), so long as those CDP holder’s CR is below a preset threshold known as the redemption margin ratio (RMR). This will enable a direct arbitrage path for iUSD that is not currently available within the Cardano ecosystem, however, this is only available in the event that there exist CDP owners with CR below the RMR (currently planned to start at 200%). As such, there exists the possibility that the DAO will need to vote to increase the RMR in order to keep this arbitrage path open in order to maintain an iAsset DEX price that is close to its peg. This could leave the DAO in the same precarious position it currently finds itself: one in which they must formally submit and vote on a proposal in an to attempt to control the overall iAsset supply or demand to stabilize its price.
Taking a step back to examine the economic dynamics at play, we can identify the various flows of assets that cause or result from a depeg. When iAssets are trading on DEX at their peg, there is a balance of supply and demand for those iAssets that is consistent with the intent of the protocol to enable their use as “stablecoins”. When an iAsset trades below its peg it is because there is an oversupply or lack of demand. One example of a cause of oversupply is the case of minting an iAsset to leverage one’s ADA position. If users are bullish on ADA’s price relative to an iAsset they can short the iAsset by opening a CDP and selling that iAsset on the open market, increasing ADA exposure. In the process of selling those iAssets for less than their peg, they are introducing excess supply into the ecosystem. Conversely, high reward incentives for depositing iAssets into protocols have resulted in high demand for iAssets and led to them trading well above their peg.
In the process of maintaining or restoring a peg, “the controller” (whether it be a person, DAO, algorithm, or other entity) is effectively attempting to relocate assets from the supply or demand side to its counterpart. Any reallocation of assets results in a transfer of value from those on the side with too many assets to those on the side with too few (for an iAsset peg equilibrium). This value transfer is why any changes the controller makes are most likely to be met with contention. In the instance of the redemption mechanism the value is taken from CDP owners in the form of the ADA they want to retain and using it to burn iAssets which are in excess supply.
What should the interest rate curve look like?
There is value in having contract terms that are as simple to understand as possible to this proposal suggests having a linear relationship between the relative depeg (iAsset market price / iAsset peg price) and the interest rate. The slope of this curve is initially set to X, but will be a parameter easily modifiable by the DAO.
Is the interest rate compounding?
No, while variable, unpaid interest does not compound. It would be a simple interest rate (updated daily) that is charged on the principle balance only.
What is the interest charged in?
Interest charged would be applied to the CDP owner and modify their CR.
You can either charge interest in the iAsset (increase their debt) or charge interest in ADA (reduce their collateral). This proposal suggests charging interest in ADA for multiple reasons.
- Charging interest in ADA allows for flexibility in how that value is used and what parties it is effectively dispersed to. The interest can go to a DAO fund which could be used for any number of purposes, including stabilizing the peg of other iAssets (even if they were not the ones that originally generated the revenue). If interest is charged in the iAsset, its value is inconsistently transferred according to the repayment or liquidation rules, depending on which occurs. In the case of repayment (assuming the excess iUSD debt is burned) value goes broadly to iUSD holders in the form of the buyback that occurred which raised the iUSD market rate. In the case of liquidation, value goes to Indy stakers and the SP in the form of a higher liquidation threshold (liquidation occurs at a higher ADA price).
- CDPs are already holding the collateral so the DAO is guaranteed to receive the interest even if the CDP is liquidated (per 1), therefore,
- It is possible to take the interest generated in ADA as it accumulates rather than having to wait until CDP repayment or liquidation.
- Typically, ADA is a CDP holders “safe” asset (asset they are attempting to maximize) so it is more of an incentive to repay their debt and/or close their positions.
- CDP holders that are longing ADA effectively “share” some of these rewards when ADA does well and it is less harmful to their position is ADA fares worse.
- A Mismatch Between Ecosystem Debt and Minted iAssets that could possibly lead to market manipulation type tactics to inflate iAsset prices is not guaranteed to occur (depending on the specifics of how the DAO uses the funds).
Who gets this interest?
As indicated by 1) above, interest would go to a DAO controlled wallet. This fund could then be used by the DAO for any variety of uses including stabilizing iAsset pegs (see Redemption Pool), furthering development, or creating additional incentives for activities such as liquidity providing (LP). Optionally, a portion of the interest could also be given to INDY stakers.
What asset is the interest applied to?
The purpose of the interest is to make it more expensive to maintain the excess debt (iAssets) in the ecosystem. As such, interest should be applied to the amount of iAssets minted in the CDP rather than the amount of collateral. If interest were to be applied to the collateral, this would promote less healthy collateralization ratios.
How often is the interest applied and claimed to the DAO wallet?
Interest would be continuously accrued most likely daily, via snapshots using an oracle which validates some median market rate for the iAsset. Technical details of the smart contract design remain to be fleshed out, but automated withdrawals of interest appear an impossibility in a trustless manner. The best alternative might be to have the CDP locked to all modifications unless the CDP owner agrees to and approves settlement and a transfer of the accrued interest as part of the CDP modification they are attempting to make.
(Discuss implications of such a complex smart contract)
Criticisms if applying interest
One might argue that having the DAO charge interest on iAssets that are under peg rewards the DAO for failing to do its job of developing robust stablecoins and that it incentivizes the DAO to be complacent with such depegs. While this is a fair criticism and it is healthy for individuals to be wary of the rationale of actors in the space, it’s also important to understand that the economics at hand and the overall benefit to the protocol are the underlying rationales for implementing interest.
The parameters used here are for the sake of simplicity of understanding and are NOT the specific parameters that are proposed.
Interest Rate Slope: 1% APR / % iAsset value below peg.
CDP iAsset: iUSD
CDP Owner Collateral: 200,000 ADA
CDP Owner Debt: 100,000 iUSD
ADA price: $1 (throughout entire example)
|iUSD market rate
Over the first 5 days, this CDP owner would accrue 95.891 iUSD worth of interest
Day 1: 15% APR * 100,000 iUSD / 365 = 41.096 iUSD
Day 2: 10% APR * 100,000 iUSD / 365 = 27.397 iUSD
Day 3: 5% APR * 100,000 iUSD / 365 = 13.699 iUSD
Day 4: 0% APR * 100,000 iUSD / 365 = 0 iUSD
Day 5: 5% APR * 100,000 iUSD / 365 = 13.699 iUSD
If the CDP owner then wanted to modify their CDP on the 6th day, as part of the adjustment contract they would have to sign to send 95.891 ADA (as the settlement rate is 1 ADA / $1 and the peg is $1 / iUSD) from their CDP collateral. Note that even though iUSD goes for $0.95 on the market on day 6, the settlement price for interest is dependent on the peg price of the iAsset, not what the oracle determines the market rate is.
Before the CDP owner decides to settle the interest on day 6, their CR is 199% as the 95.891 ADA worth of interest is deducted from their collateral in the calculation for their CR (199,904 ADA / 100,000 iUSD).