SILK has been consistently trading above peg in all of its pools. Fundamentally, this is due to excess demand – there is more capital interested in holding SILK than there is capital interested in borrowing SILK. In the current market conditions, this isn’t surprising. Borrowing, and in particular high leverage positions, are typically in low demand during a bear market.
Another difficulty with SILK is its overcollateralization. Maintaining a high collateralization ratio for SILK is critically important for the following reasons:
- Network Resilience. Secret Network is experimental technology, and it is not expected to maintain 100% uptime. There can be extended periods of downtime during which time we cannot liquidate risky positions. There needs to be sufficient collateral backing to ensure SILK remains sufficiently collateralized even if the value of its backing drops significantly during an extended period of downtime.
- Market Resilience. Crypto is a high volatility space and sudden price changes are not unusual. Large drops in prices can result in the accumulation of bad debt. The protocol is able to repay bad debt if it accumulates, however even the simple creation of bad debt does not harm SILK as long as it remains overcollateralized in aggregate. Maintaining a high collateralization ratio using a diverse portfolio of collateral allows SILK to withstand sudden market changes, even if bad debt is forced to accumulate.
- User Experience. Safety mechanisms for SILK such as redistributions prioritize the solvency of SILK over preservation of user capital. As such, runaway liquidations that exceed the balance of the stability pool could result in users being forced to take on higher LTV debt positions that they did not originally want. Maintaining a high collateralization ratio ensures that even in such cases, the impact to user positions is minimized.
- Mitigation of Tail Risk. This is essentially #1 and #2, but there are other long tail risks associated with smart contract CDP coins like SILK, such as bridge risk (e.g. a bridged exploit suddenly dropping the value of a token to $0). Maintaining a high collateralization ratio with a diverse portfolio of assets with uncorrelated tail risk allows SILK to remain strong even if bad debt accumulates due to such tail risks.
Unfortunately, the high collateralization ratio of SILK reduces the capital efficiency of borrowing, which requires significantly more capital to flow into Shade Lend to create enough SILK to meet current market demand. We do not believe it makes sense to compromise the collateralization ratio of SILK in Shade Lend to increase the SILK supply. Security is the protocol’s paramount value. The SILK brand and the market’s confidence in SILK as a currency rests entirely on the protocol’s commitment to the protection of SILK’s backing, and we believe that compromising this to meet the short term goal of satisfying excess demand is short sighted.
The stability mechanism for SILK in an above-peg situation is the ability for users to borrow at peg value, and immediately sell the SILK for profit on the open market. However, this is contingent on there being demand to borrow in the first place, as well as confidence that SILK will return to its peg. In order for one to realize profits with this arbitrage, they must wait for SILK’s market price to decrease below the price they sold at, whether through the peg decreasing, or with excess demand being absorbed by increased supply. With dollar-pegged stablecoins, there is generally greater confidence that the stablecoin will return to its $1 peg, although in current market conditions even comparable stablecoins such as USK and LUSD are struggling to meet excess demand. SILK faces a unique challenge because it is not pegged to the dollar, so an arbitrageur not only takes on the risk of SILK not returning to its peg, they also take on the risk of SILK’s value appreciating and eliminating their potential profits.
The combination of SILK’s unique risk profile and current market conditions means the protocol must consider other options to meet excess demand without compromising the security of SILK.
As an alternative, we propose a protocol intervention using Automated Market Operations (AMOs) to meet the excess demand. The AMO we propose is:
- A programmatic mint of SILK
- The SILK is deposited into all liquidity pools on ShadeSwap that are valuing SILK above current market price
- This creation of SILK reduces the market price in the pools to the current peg value, and allows arbitrage on the open market to resume stabilizing the price around the peg now that all pools are balanced around the peg.
- If SILK begins to fall below peg, the protocol now has a lever to withdraw this liquidity and burn the SILK to absorb excess supply.
As an example, let’s consider the current average collateralization ratio of SILK is 170% with $3,000,000 SILK in supply, meaning there is $5,100,000 in collateral backing those loans.
There are multiple ways of treating the SILK minted by an AMO. We could consider it 0% collateralized because it is not backed by loans. This is a pessimistic approach, allowing us to think about what happens if all of this AMO-minted SILK entered supply immediately. However, this AMO-minted SILK would be added to a liquidity pool, and it would only enter circulation when it was purchased for market value, meaning that this AMO minted SILK is more accurately 100% collateralized. This also does not tell the whole story though, because SILK is likely to slowly appreciate over time. If the SILK is purchased at a price of $1.05 when the peg is $1.05, then this SILK is 100% backed. If SILK appreciates to $1.10, that SILK that was originally purchased for $1.05 remains “backed” by $1.05, leaving a $0.05 gap between the value backing SILK and the actual market cap of SILK.
How can we address this gap?
- SILK remains primarily minted through Lend, where it is overcollateralized. For example, even if 50% of the SILK supply in circulation was purchased from AMOs rather than minted through Lend, and Lend maintains a 170% collateralization ratio, SILK would have to appreciate by 70% in order for SILK’s total collateralization ratio to drop to 100%, assuming that no additional SILK is minted from Lend during this time, or that no SILK is withdrawn from the AMO during this time. This is well outside of the realistic price movement of SILK, even over an extremely long time period, and the assumption that SILK growth through Lend completely ceases is also unrealistic. Even in this extreme case, SILK remains completely collateralized.
- This theoretical gap would manifest as a decrease in the market price of SILK, which means there would be excess supply. The protocol could simply withdraw the SILK from the AMO which would increase the market price of SILK, giving the protocol an additional lever to address a potential shortfall without deploying any capital from the treasury.
- When SILK enters circulation through the AMO, the protocol has effectively sold that SILK for current market price. This creates a reserve of funds that the protocol is able to use to re-purchase and burn SILK if it is unable to withdraw enough SILK from the LP to cover what has been minted through the AMO.
Q: Isn’t this printing money out of thin air?
A: Technically yes, however because the minted SILK is deposited into a liquidity pool, it only enters circulation when it is purchased by someone. As more of this minted SILK is purchased, the market price of SILK will increase, which is a natural deterrent to a sudden increase in the circulating supply of SILK. In effect, it would be like a Reserve Mint of SILK, where a user would mint SILK without opening a loan position. No SILK enters the open market without at least 100% backing. Even if the price of SILK appreciates from the purchase price, the majority of SILK remains overcollateralized through lend, giving an extremely large range of SILK that the protocol can mint without significantly harming the overcollateralization of SILK.
Q: Isn’t this just like LUNA and UST?
A: No. UST’s collapse was due to an extreme imbalance between liabilities in the form of UST, and collateral in the form of LUNA. SILK maintains a strong collateralized backing through Shade Lend, and the SILK that enters the market through the AMO is exchanged for at least 100% of its fair value, maintaining its collateralization.
Q: Isn’t this stealing money from LPs?
A: Since the protocol will be providing liquidity to these pools and receiving LP tokens, a portion of the swap revenue will be taken by the protocol. This will result in slightly lower fee income for current LPs, however the protocol will not stake its LP shares, meaning the primary source of income through emissions will not be reduced by these AMOs.
Q: What will happen when the SILK is withdrawn from these pools?
A: The AMO will prioritize withdrawing SILK only and burning that SILK until all of the SILK it originally minted is burned. Any excess LP tokens will be withdrawn as the other asset in the pool as revenue. For example, if the protocol mints 1,000,000 SILK for an AMO in the SILK/USDC pool, and next year that LP position is worth 1,100,000 SILK, the protocol will withdraw 1,000,000 SILK first and burn it to ensure no excess SILK remains on the market, and the remaining 100,000 SILK would be withdrawn as USDC from the liquidity pool as protocol revenue. In the event that the opposite occurs, any shortfall from an AMO withdrawal will be covered by protocol reserves.
Q: How does this impact existing and future borrowers?
A: This AMO strategy is a commitment from the protocol to address the market price of SILK and bring it closer to peg. As of writing this post, the market price is above peg, so this proposal would reduce market price of SILK. Borrowers are naturally short on the asset they are borrowing, meaning this would create profit for existing borrowers if they were to sell the SILK they’ve borrowed before this operation commences, and then re-purchase it to repay their loans after this operation. The game theory of this means that if the protocol publicly commits to improving SILK’s market price against its peg, it would naturally drive borrowing activity as capital would flow in to capture the “guaranteed” arbitrage. Such an outcome would eliminate the need for the protocol to utilize an AMO at all. For under-peg scenarios, borrowers are able to purchase discounted SILK on the market and repay their loans for profit. If there is AMO SILK in liquidity pools, then there is another mechanism for the protocol to absorb excess supply, meaning there is less opportunity for future borrowers to capture profits from under-peg scenarios.
Q: How does this mechanism wind down?
A: The AMO can simply withdraw SILK from liquidity pools and burn it. The AMO keeps track of how much SILK is minted for LPing, and must withdraw and burn at least that much SILK. If the AMO has any LP remaining after the full amount of SILK minted has been burned, it will withdraw that LP as the non-SILK portion of the pool as protocol revenue. In the event the opposite is true, and the AMO is unable to burn the full amount of SILK it minted from withdrawing LP, the protocol may cover this gap with reserves. See the “How can we address this gap” section above for more details.