Summary

The goal of this proposal is to:

• Immediately alleviate the existential undercollateralization risk facing iBTC.
• Lower the risk of running a vault
• Generate capacity for more iBTC

Therefore, the proposal suggests

• Increase liquidation ratio for vaults to above the current iBTC premium of 7.3% until iBTC settles back at par
• Lower the premium redeem threshold to the liquidation threshold, thereby putting it out of use entirely
• Update collateral thresholds with new model and new price data to partially reduce thresholds and increase total mint capacity by up to 15%

Existential risk

Problem

Due to a supply crunch and the incentive scheme on Hydration, iBTC is trading at a premium to wBTC and is in high demand by users and arbitrageurs alike. The Stableswap pool on Hydration contains 53.384 wBTC and only 35.528 iBTC because users have been depositing one-sided liquidity. By doing so, they are earning the incentive rewards, but also effectively swapping half their wBTC for iBTC. Due to this mismatch of pool balances, the price of 1 iBTC is currently 1.07367 wBTC, down from a high of 1.135 wBTC last month.

This premium has not only made it difficult for vaults to manage their risks, but it has also made the premium redeem function useless. Premium redeem is a tool given to vaults that incentivizes other users to redeem against them, which has the desired effect of bringing the vault's collateral ratio back into a safe range. For this action, the vault awards the redeeming user with a 5% redemption fee. For the past few months, and during multiple black market days, vaults have been unable to rely on premium redeems. There's simply no reason for anyone to use their iBTC to premium redeem when they can just sell it for 7.3% bonus. However, premium redeems are merely a tool for vaults and not integral to Interlay's survival.

A much more existential threat for Interlay lies in the inadequacy of the iBTC burn bonus. When a vault is liquidated, it is closed down and its collateral goes into a pot against the outstanding iBTC debt it "owes". Anyone can come in and burn iBTC and receive an equal proportion of the collateral in the pot. Currently, liquidation ratios are set at 105% across the board for all collateral types. At this ratio, the backing collateral is not enough to incentivize anyone to burn their iBTC. Let's take a look at an example:

Example

1. Vault A has $150 in DOT collateral and issued $100 in iBTC.
2. A black swan day causes DOT to fall by 30% in a matter of hours.
3. Vault A now has $105 in DOT collateral and $100 in iBTC issued, causing a liquidation bot to liquidate the vault.
4. The liquidation account now contains $105 in DOT collateral and anyone is now able to burn up to $100 in iBTC to receive $105 in DOT.
5. However, since iBTC can be sold for $107.3 in DOT on Hydration, nobody will elect to burn any iBTC.
6. If DOT now continues to fall, the collateral in the liquidation account could potentially fall below the $100 it has outstanding in iBTC debt, which would result in the collective undercollateralization of iBTC, an existential threat to the protocol.

Solution

The solution for the risk of undercollateralization is easy: we increase the liquidation threshold to 110%. This guarantees at least a 2% bonus for burning over selling iBTC on Hydration. We can adjust it up further if the Hydration premium climbs above 10%, though the chance of this occurring is low due to part two of this proposal.

The solution for premium redeem is a bit trickier. Vaults barely earn rewards these days and a single premium redeem can easily put one in the red. I therefore propose further lowering the premium redeem threshold, effectively making it useless. This gives vaults a bit more breathing room to maneuver and rebalance in without risking a debilitating premium redeem. Increasing the liquidation threshold adds enough security to the Interlay protocol that we no longer require the poorly designed premium redeem functionality.

Increasing capacity

Problem

To further alleviate the iBTC/wBTC imbalance, we need more capacity. A tool available to us is increasing capital efficiency of USDT, USDC, qUSDT, and qUSDC vaults. These are currently all set to a very conservative 150% safe mint threshold. In the past few months, they have proven to be the most stable vaults.

On black swan days, altcoins (like DOT and VDOT) tend to suffer larger drawdowns than BTC. As a result, we see liquidations on these days for such vaults as their collateral is more strongly hit than the value of iBTC issued. For stablecoin-backed vaults, heavy crypto drawdowns make the vaults safer. Collateral ratios only fall for these vaults when BTC appreciates, which generally happens more steadily. These vaults thus have more time to rebalance their collateral.

Solution

From this, we can argue that stablecoin safe mint thresholds are too conservative. Vaults should be free to set lower thresholds, which will increase capital utilization and vault operator rewards.

Collateralization Analysis

I have updated the collateralization analysis to pull the current iBTC premium from the Hydration stableswap pool. This is reflected in the threshold ratios computed by the collateralization-analysis. Here is the pull request: https://github.com/interlay/collateralization-analysis/pull/14

The result of running the analysis on the existing collateral tokens shows that we should absolutely increase the liquidation ratio. Given that this analysis is based on VaR, some real-world nuances are not considered. We should therefore err more on the side of caution for the stablecoin vault thresholds:

Proposal

Currently, thresholds are set to:

I propose changing these thresholds to:

• I see no reason to increase or decrease collateral ceilings in this proposal.
• Lend tokens are less liquid than their underlying tokens as lend markets could be fully utilized. This adds a certain risk factor.
• The premium redeem was designed as a safety tool that would prevent liquidations. It is neither working as intended nor popular among vault operators. Therefore, it should go.

Questions

Why aren't we just increasing/decreasing premium redeem fees instead?

• Premium redeems were meant as a tool that gives vaults more safety, as they incentivize other users to bring your collateral back into a safe zone. However, this has been abused in the past for gain, as users would completely drain vaults only to fill them back up. The fee was lowered to 5% as this was too painful for vault operators. Now it just seems superfluous to have two back-stops. Vaults can either manage their own collateral ratios or they run the risk of being liquidated.

Will this negatively affect vaults that are already hovering around low collateralization ratios?

• Yes, three vaults are currently sitting between 115% and 120% and one vault (165 DOT) is close to the new liquidation ratio. The first three have been near the threshold for multiple days now and should have acted already to rebalance. Ample warning will be provided in the discord should this proposal be passed. The fourth vault (sitting at 111% ratio) has also not taken any action either. If it was liquidated, it would be collateral damage for the good of the protocol.

Treasury

This proposal remunerates me for the following:

• Analysis of current Interlay conditions and vault risks - 2h
• Pull request for collateralization-analysis - 1h
• Chopsticks testing - 1h
• Crafting proposal and preimage - 1h

This proposal remunerates spazcoin for their collaboration - 1h

At $100/hr, this will cost the treasury a total of $600 or 45,000 INTR ($0.01333/INTR)