On August 29th, 2023, the SILK <> USDC and SILK<> USDT LP ratios shifted from historically having more USDC/USDT to having more SILK. This event was the likely result of a large SSLP of SILK following a large SILK minting event in the ETH vault.
As a result of the shifting of this particular LP ratio, this offered a very lucrative route for swapping from volatile assets (such as ETH, stATOM, stOSMO, stkdSCRT or wBTC) to USDC and USDT as a result of SILK being the routing token. This activity continued further increasing the amount of SILK in the stablecoin LPs which ultimately drove down the market price of SILK. Considering the largest impact on the market price for SILK is depth of liquidity, the asymmetric concentrated liquidity in the stableswap pools impacts market price on DEXs more than CPMM pools with equivalent volume.
As a result of the “depegging” - (market price below that of peg price), arbitrage opportunities opened up for those who have open borrow positions. This arbitrage existed (and still exists) for those individuals. An example of the opportunity present for borrowers:
John deposits 10000 USDC and borrows 7000 SILK at a 70% LTV (value of loan is based on peg price not market price).
John then goes and does something with his SILK (LP/Swap/participate in liquidations)
Time passes and the market price of SILK drops 5%
John can now buy SILK at a 5% discount (market price of SILK vs peg price) and pay back his loan (value of the loan is based on peg price not market) and keep the extra SILK as profit.
In this scenario, borrowers decide what discount they are willing to accept to pay back their loan early by purchasing SILK (if they didn’t just keep it liquid - for reference only 2.3% of SILK is “liquid” and not LP’d or deposited into Earn Pool for liquidations).
Over the course of the past 5 weeks, we have seen a lack of appetite for borrowers to repurchase SILK and pay back their loans at a discount and capture profit. As a result, the protocol started instantiated interest fees for USDC, USDT, and stkATOM collateral vaults to encourage early repayment. While the introduction of interest fees for particular SILK vaults is beneficial for a variety of reasons (including but not limited to additional fee streams for the DAO, reduction of centralized asset backing, and mechanism to encourage borrowers to reduce the % discount at which they’re willing to repay loans early), it does not create the level of urgency necessary to help return market price of SILK back to the peg price in a short time frame.
Stability Defense Mechanism:
In the very near future, the DAO will take action to defend the stability of SILK’s price via a previously unused stability mechanism previously built into the ShadeLend dApp called Redemptions.
Prior to the enabling of redemptions, the SILK allowances for all collateral vaults are being temporarily decreased to 0 while the redemption stability mechanism is being further tested. Shortly after this testing is finished, SILK allowances for all collateral vaults will be increased to their previous cap.
Redemption Mechanism Overview:
The redemption stability mechanism allows for the purchasing of SILK on the market and subsequent Redemption for the collateral of choice. Redemptions repay a pro rata share of the Vault’s debt and return a pro rata share of the Vault’s collateral to the redeemer.
For Redemptions, the price of SILK is determined by the peg of SILK, not the current market price. This means that if the market price is below the peg, then it is profitable to purchase the cheap SILK and Redeem it, then sell the collateral for profit. It is not profitable to redeem collateral when SILK’s market price is at or above its peg price because of the associated fees.
In order to discourage excessive Redemption activity, there is a variable Redemption Fee. There is a minimum Redemption Fee of 1%. This cannot be changed. The Redemption Fee increases as Redemption volume increases, ensuring that supply absorption during extreme changes in market demand is not too sudden, giving borrowers time to repay their loans voluntarily. Half of the redemption fee is awarded to the borrowers pro rata, meaning that Redemptions will always be profitable for borrowers.
All borrowers in Lend are eligible for Redemption – while there are systems in place to discourage excessive redemption and ensure redemptions are always profitable for borrowers who fund the Redemptions, your collateral may be sold without notice to honor Redemptions.
Actions to be Taken:
The DAO will be performing redemptions on various Lend vaults (redeeming SILK for collateral assets), and swapping the collateral for SILK in order to drive the market price for SILK back to its peg price. As a result of the cycles of collateral redemption and open market swapping, the DAO will be able to successfully push the market price of SILK back to peg while still ensuring that borrowers are still in a profitable position (as a result of the repayment of debt pro rata and distribution of part of redemption fee).
For this first cycle of redemptions, redemptions will be permissioned and only possible by the DAO. In the near future, we will release documentation on how to interact with redemptions via CLI.
The net result of the following action for all relevant parties will be as follows:
Liquidity Providers for SILK / Collateral pools (stATOM, wETH, stOSMO, USDC, USDT, wBTC):
- Current LP ratio will shift to have SILK as lesser supplied asset and collateral asset being more supplied
- Price impact of LP positions should be positive as SILK price goes up and sell pressure from redemption cycle gets smoothed out be cross-chain arbitrage is performed so changes in collateral asset price are negligible
- LPs earn more in swap fees from increased activity
Borrowers in all vaults:
- Borrowers will notice their collateral deposits shrink at a pro rata share
- If total deposits for USDC are 1M and 10,000 USDC are redeemed (1% of total collateral), each open position will have it’s collateral deposit reduced by 1%)
- Borrowers will notice their debt decrease at a pro rata share + ½ the redemption fee
- If a user then paid off the rest of their reduced debt, they would unlock their collateral and still have some remaining SILK left from the distribution of redemption fee.
- As a result of looping redemptions, the market discount that could be taken advantage of by borrowers is instead captured by the redeemer (until redemption fee exceeds the market discount).
- DAO earns a portion of the arbitrage profits from selling redeemed collateral for SILK at market discount.
- DAO earns portion of redemption fee
- DAO earns additional swap fees
- DAO distributes additional revenue generated to SHD stakers via SHD buybacks and redistribution.
- SILK price returns much closer to peg price allowing users to more easily provide liquidity at proper ratios.
- SILK supply shrinks as a result of SILK being burnt upon debt repayment.
It is important to note that this stability mechanism defends the price of SILK, not the solvency. SILK’s overcollateralization rate, and by extension its solvency, remains high at 195% meaning that there is more value in SILK’s collateral backing than liabilities issued in the form of SILK (evaluated at peg price).