Assessing Centralized Counterparty Risk in regards to Silk Collateral Backing

Shade Protocol
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Lately I have been pondering the impact of traditional bank and centralized counterparty failures on Decentralized Finance. Given the (likely) instability that exists within traditional finance currently, it has caused me to revisit my take on the role and risks associated with centralized stablecoins in DeFi, particularly with regard to their use as collateral for decentralized stablecoin backing.

In the forum post by SBeem titled “Launch Plan for SILK + Lend” , the following stablecoin vaults and their respective Max LTV’s were proposed for launch:

  • IST - 85% max LTV
  • DAI - 85% max LTV
  • FRAX - 85% max LTV
  • USDC - 85% max LTV

Context regarding vault parameters for ShadeLend

LTVs can be adjusted by the governance admin, but they can only be increased, not decreased. The LTVs are intentionally conservative at launch, but will change in accordance with the relative risk of the collateral as liquidity deepens on ShadeSwap.

The approximate range for interest rates will be 0.5%-2% for stable collateral. In addition, a riskier collateral will have a higher target interest rate than a lower risk collateral.

For more information regarding the Stablecoin Trillema and the relative risks and rewards for various types of stablecoins, check out SILK - Stablecoin Trillema & Operation Touch-&-Go (Security, Efficiency, Stability).

Ultimately, in order to facilitate liquidations of vault debt users must be willing to buy distressed collateral in exchange for their SILK. Therefore, users will need to WANT to acquire the distressed assets and accept the risks that come with them.

Taking into consideration the relative risks of the various stablecoin types that we plan to accept as collateral to mint SILK, I believe it is worth starting the discussion about the risks (and rewards) that we, as Shade Protocol community members and SHD token holders, are willing to take on as it relates to protocol solvency. This discussion is not meant to completely discourage the acceptance of centralized stablecoins as collateral backing, but rather stimulate a discussion as to how the protocol could assess and account for the various risks each stablecoin type poses.

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If we refer back to many of the commentaries we’ve heard over time in relation to “decentralised stablecoins” that are predominantly centralised stablecoin-backed assets, we’ve listened to many of the following:

  • Centralised stablecoins as collateral, through a PSM, offer a faster route to scaling decentralised stablecoins. This is because users do not have to provide collateral in excess of their loan.

  • Centralised stablecoins growing in terms of total collateral make the decentralised stablecoin vulnerable to price volatility in the underlying stablecoin. This was seen with $DAI and $USDC where $DAI was effectively trading at par with $USDC even though it boasts a wide range of other collateral.

Note that MakerDAO implemented a cap on the PSM per stablecoin asset, but these were in terms of nominal amounts (i.e., just leveraging the PSM will make the stablecoin collateral % increase over time).

I would suggest that a more prudent way to go about a PSM if you are willing to sacrifice some speed of scaling would be to implement a PSM that looks more like:

  • USDC.axl = 1.25% of total nominal $SILK
  • USDC.grv = 1.25% of total nominal $SILK
  • USDT.axl = 1.25% of total nominal $SILK
  • USDC.grv = 1.25% of total nominal $SILK

While the numbers and stablecoins are just random and for example, it is based on the fact that the PSM should expand and contract as $SILK in itself grows.

This means that if more people are entering $SILK through volatile assets (under the usual CDP-based mechanism), more people are also able to enter $SILK through the PSM and vice-versa.

Once you’re at the percentage-based cap, people will not be able to enter $SILK through the PSM. Moreover, if $SILK were to contract (through CDP-based vaults), then it would basically make the PSM re-opening further away.

I question if there would need to be an incentive mechanism for people to exit through the PSM at times like this to ensure that the percentage of stablecoin collateral does not grow beyond the desired limits.

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I like the idea of keeping Stablecoin minting (I think it is fair to call PSM that way) relative to the total supply and you also made a good point about the incentive mechanism for exiting PSM at times when CDP/PSM ratio has decreased disproportionately.

I want to expand a bit by trying to answer the questions: Why would the protocol reward exiting PSM positions in those times? What does it mean when a lot of people have started redeeming their collateral burning their non-PSM $SILK and thus increasing the PSM ratio?

It might mean at least one thing:

  1. A market downturn - collateral value supplied through CDP has decreased disproportionately relative to PSM stablecoin minting.
  2. ???

Those times are also times of volatility expansion. When volatility is expanding it is accompanied by either a market price move to the upside or to the downside. A market downturn might be problematic and thus exiting through the PSM would be needed to avoid “protocol stablecoin risk” because of vollatile assets losing value and increasing that risk.

So let’s say you minted $SILK using stablecoins (PSM) in the period prior to the volatility expansion. Thus you brought extra stability to the $SILK protocol as more stablecoins would have allowed for more minting using volatile assets and greater downside protection. It would also mean that you are “missing out” on the market opportunity of the expansion (as expanding volatility is marked by an increased market risk and thus the potential rewards are increased). So, if you were to redeem your stablecoins at some point when volatility has already begun to increase it would make sense to be rewarded for your participation in $SILK during the times when you missed out on the opportunity to use your stablecoins to generate that alpha. The exact formula has to be modeled after further analysis.

This theory suggests that “extra rewards for redeeming stablecoins through PSM” might be an indicator of how “governance” sees downward pressure on the market. Voting on such rewards can be a proxy to betting on market conditions - more precisely volatility conditions. For example, creating a market for betting on volatility expansion through such rewards would be an interesting addition and if such market is big enough on Shade it might be useful as a means to control other rewards that depend on volatility or can be used as a hedge for other market strategies. In any case that would mean that SHD has enough markets to capture such volatility and generate revenue as it would basically be expanding SHD to fund low volatility periods.