Backing the protocol’s liabilities produced though the Seniorage process, in the form of FXS, with the over-supply of collateral generated by fraxlend’s lending activity though the use of FXS denominated Interes Rates and Dynamic Collateral Requirements for the creation of new CDPs.
(Grant a 20k FXS compensation for the development of the model and an advisory role to Liscivia to oversee its development and success.)
The recent UST depeg event has lit a light on the importance of security and full collateralization of stablecoins.
In this context, algorithmically backed or undercollateralized stablecoins are quickily loosing ground in terms of popularity and community trust in favor of overcollateralized designs such as MakerDAO’s DAI.
This is understandable.
Overcollateralized designs, though, also suffer from specific issues such as:
Governance vs Users:
The Govenance (long peg) mostly profits when Interes Rates are high aka during the contraction phase/bear market.
During these market conditions demand for leverage/risk is low and so is the rate of adoption, consequently the market capitalization is expected to shrink.
Users (short peg), on the other hand, tend to seek risk/open a CDP during the expansion phase/bull market when Interest Rates are low, therefore Governance isn’t profitable.
When the market is bull , there is not much demand for stability and moreover the earnings are low (low Interest Rates)
When the market is bear, even if the Interest rates are high, the m.cap is still shrinking because Users are de-risking
These problems can be identified as a scalability bottleneck for money markets in general.
Seniorage, on the other hand, allows for incentives to be aligned for inclusion, growth and equity decentralization but not for security.
Utilize Fraxlend’s oversupply of collateral to fully back Seniorage’s liabilities.
For this purpose I suggest the implementation of two new forms of collateral ratios:
UCR and OCR
- Undercollateralized Ratio or UCR: Refers to that % part of FRAX’s emissions covered by FXS, the “unbacked” part.
- Overcollateralized Ratio or OCR: Refers to the % of excess collateral supply present in Fraxlend and backing CDPs.
To obtain FRAX’s full collateralization OCR and UCR have to remain balanced in Dollar terms.
This allows emissions to remain unbalanced between the Seniorage process and Fraxlend.
Example 1 (Same volume of emissions):
-100$ total FRAX emitted from Seniorage.
80% CR, 20% UCR = 80$ of collateral and 20$ of FXS
-100$ of FRAX emitted from Fraxlend.
20% OCR = you need 120$ of collateral to open a CDP and borrow 100$ of FRAX
UCR 20$ = OCR 20$
Example 2 (Different emissions between Seniorage and Lending):
-200$ total FRAX emitted from Seniorage.
80% CR, 20% UCR = 160$ collateral and 40$ of FXS
-100$ of FRAX emitted from Fraxlend.
40% OCR = you need 140$ of collateral to open a CDP and borrow 100$ of FRAX
UCR 40$ = OCR 40$
These examples allow us to understand how the introduction of Dynamic Collateral Requirements (DCR) in needed to provide the protocol with the necessary flexibility to withstand demand fluctuations between the Seniorage and the Lending minting process.
(aka DCRs allow UCR/OCR’s $ value to remain balanced even if emissions vary between the two minting processes)
DCRs would resemble what regularly already happens within legacy lending.
When a new CDP is opened the User would need more or less collateral to obtain a bigger/smaller FRAX loan, according to OCR/UCR.
These terms remain fixed until CDP repayment.
Interest Rates float to incentivise repayment or the opening of new positions.
Moreover, to allow redemptions through Seniorage at 100% collateral value, regardless of the % of CR, Interest Rates have to be paid in FXS.
If Fraxlend emissions correspond to 100$ in FRAX and the collateral is worth 150$, Users will be ok paying up to 49$ in FXS as Interest Rates to redeem the collateral inside the debt positions.
This system would allow FXS to sustain a floor price which would be proportional, in $ value, to the oversupply of collateral present in Fraxlend, effectively allowing the algorithmic portion of FRAX to be backed by Fraxlend’s collateral oversupply, attaining capital eficiency and allowing redemptions to happen at full collateralized value even through Seniorage.
(In a real world scenario the makret should also price FXS’s P/E ratio on top of its floor value, provided by hard collateral. So, actually, FRAX would always be more collateralized than 100% as long as FRAX’s business is producing earnings)
Let’s analyse how this model would work during both market phases:
Contraction (bear market):
- CR of the Seniorage
- Less collateral requirements in the MM to open a CDP⬇️OCR⬇️
- IR hikes (paid in FXS)to force CDP repayments
During the Contraction phase the sell pressure on FXS, caused by its supply expansion through the Seniorage process, is counterbalanced by the buy pressure due to IR hikes from Fraxlend.
Demand for leverage decreases in a bear, so does the OCR, incentivising loans (Incentives align)
Expansion phase (bull market):
- Seniorage’s CR
- OCR⬆️( Demand for leverage increases in a bull, so does risk = less FRAX lent and more collateral gets required in CDPs)
- IR but since FXS’s value is increasing due to Seniorage, the business stays profitable
In a bear phase “Demand for leverage decreases[…], so does the OCR, incentivising loans”
In a bull phase “IR but since FXS’s value is increasing due to Seniorage, the business stays profitable”
These are exactly the problems that overcollateralized stables face in terms of profitability, adoption and therefore scale, which are resolved in this case by applying the undercollateralized incentives structure to the model.
On the other side of the equation, by adding the security of an overcollateralized stablecoin, we solve the scalability issue of the undercollateralized design.
As you can now understand, the complementary nature of undercollaterlized vs overcollateralized stablecoins match in this model, ultimately fixing each other issues, achieving scalability and sustainability.
Implementation of UCR for the Seniorage minting process and OCR + FXS denominated Interest Rates + Dynamic Collateral Requirements in the upcoming Fraxlend’s design.
(Grant a 20K FXS compensation for the development of the model and an advisory role to Liscivia, to oversee its development and success.)