Let’s think about what does an under-peg means.
It just means people who have minted SILK against their volatile collateral, have now sold that SILK on the open market - usually for stables. That marks ultra-bearish conditions where people are willing to potentially give up their collateral in order to hold “hard stables”. It is both a short on SILK and a short on their collateral. I am assuming people who have minted SILK against stables are not part of that cohort and would NOT sell their SILK for stables as they would rather repay their SILK to get back larger % of their stables.
So given that people have shorted the entire market through minting SILK and then selling it, it makes sense to incentivize people to take the opposite side of that trade.
Thankfully the design of the protocol provides the basis for such a mechanic, but those mechanics can be further improved.
Let’s start from the basics:
One obvious way for each individual volatile minter to benefit from the under-peg is to sell part of their volatile collateral (that now has an increased effective health because of SILK being cheap on the market) and repay their position. They effectively sell their collateral for a 3% (when depeg is 3%) premium above the market price. They are effectively repaying their loan when SILK is being the cheapest - increasing their health in peak bearish times = good for them.
Things to note:
- While those secondary sellers of volatiles are effectively contributing to the short market conditions introduced by the de-peggers, they are ALSO recovering the peg and as such are disincentivizing the de-peggers to continue shorting SILK against stables. The
primary shorterssee the depeg conditions recover AND their volatile mint positions get in poorer health and see that they will need to get back into SILK at higher prices to avoid liquidations. - The
secondary shorterswho sold part of their volatile collateral during peak bearish conditions can encounter 2 scenarios - either the price of their volatile begins to recover BACK in which case they would need to mint SILK back and use it to buy back and recover their volatile exposure. Thus they contribute back to the depeg (losing on some swapping fees). The other option is for the price of their volatiles to go back more - this is the best scenario and they have hedged against it with a good premium. - So, now the game becomes an economic battle between the
primary shorterswho are ready to be liquidated by the short market conditions and thesecondary shorterswho maintain healthy mint positions with a 3% premium. One more thing to note is that theprimary shortersare always ready to deploy theirstablesto mint SILK. Another analysis is needed for bringing a higher tax for minting SILK using stables in depeg conditions this thread. Long story short - such bearish conditions would usually correspond to stables being a big part of the backing of SILK - low volatile assets price vs stables - and thus SILK having an increased centralized risk.
Now back to disincentivizing minting and selling of SILK is a borrow fee. This way those who lack SILK will faster reach a point of liquidation, while those who reduce their position will pay less in terms of fees because of the premium they receive for reducing their exposure. So the borrow fee would essentially need to increase with the furthering of depeg conditions. It will act as a catallizer for faster liquidations during depeg periods. It will also punish minters in general which has to be evaluated.
One thing to note is that the borrow fee should be such that it slowly liquidates a position back into SILK and thus brings the peg up.
This process in turn will also reduce the borrow fee back to a 0 peg.
Having such dynamic borrow fee is extremely important for a monetary protocol to be healthy – the borrow fee should INCREASE when market conditions are tough in order for borrowers to reduce their risk
In summary - a combination of a dynamic borrow fee which increases with a SILK de-peg AND a dynamic minting fee via stables in peak bearish conditions would reduce both the depeg conditions and the risk of SILK being backed primarily by stables.
However let’s do the due diligence and analyze the counterpoint. What if market conditions deteriorate further - volatile assets drop further, SILK continues to lose peg and borrow fee increases. What would that mean for SILK? Let’s analyze each one by one:
- Volatile assets dropping further means that the
secondary shortersand theprimary shortersare both winning. What the protocol needs to ensure is that theprimary shortersare paying a premium for being out of SILK in a depeg conditions. This is where theborrowing feewould come into play. It would slowly increase the SILK being owed by theprimary shorterswho lack SILK to repay their positions. Furthermore, in such conditions the stable part of the backing of SILK would increase in proportion to the volatile one. This would entail a bigger tax to be incurred (or even entirely blocking) a stable minting of SILK. This way theprimary shorterscan only buy SILK via their stables and not mint it. - The borrowing fee would increase. That means that everyone on the platform is incentivized to reduce their exposure to SILK. Those who should be the most incentivized are those who have minted SILK using volatiles as their positions are becoming the most at risk. They can afford selling some portion of their volatiles and reduce their risk by a larger margin because SILK is trading below peg. They would incur less penalty from the borrowing fee increase because they have decreased their mint position.
The question in such a mechanic is how to design the borrowing fee mechanism, i.e how do you fairly put a fee on holding a SILK mint position in de-peg conditions?
The second question is of course - how much do you want to punish SILK minters via borrow fee in order to incentivize healthy behavior during depeg and disincentivize shorting during depeg. How much do minters want to pay for the disincentive mechanism for punishing depeggers (bad minters)?