How Not To Lose $1.8M In a Day
Understanding Instant Redemptions, Instant Liquidation, Recovery Mode, and Collateralization Ratios on AstridDAO
A few weeks ago, an AstridDAO user we’ll call Mike lost $1.8 million in a day.
Yep, you read that right.
$1.8 million lost in a day.
Yikes.
That’s a lot of money to lose in a lifetime, let alone in a day.
Now you might be asking yourself:
Why did this happen?
How did this happen?
How can I make sure that never happens to me?
Simply put, Mike was under-collateralized, and he got instantly liquidated.
Before we go any further and get into the weeds of what these terms mean, let me reassure you that what happened to Mike doesn’t need to happen to you!
In fact, if you take proper measures, it’s almost impossible for you to experience the same unfortunate fate as our friend Mike.
That’s what this article is about. Learning. It’s been said that the wise ones are the ones who learn from others’ mistakes. So let’s be wise, shall we?
How can we do this?
Through radical self-responsibility and full ownership of our education.
I have a few goals for this article.
- I want to arm you with knowledge about AstridDAO and our stablecoin, $BAI
- I want you to understand the mechanics of how our lending/borrowing protocol works
- I want you to know what pitfalls to avoid so that you don’t lose money
A Quick Introduction Before We Begin
Before we begin, if you don’t know about AstridDAO or $BAI, let me give you a quick rundown. AstridDAO is a decentralized money market protocol with a stablecoin called $BAI.
This means we are a lending and borrowing platform with our own stablecoin. It’s that simple.
The money you borrow on AstridDAO is a stablecoin called $BAI.
$BAI is hard-pegged to the U.S. dollar. Don’t worry about the mechanics of how hard-pegging works for now. Just know that 1 BAI is worth 1 USD.
You can borrow $BAI as long as you put up a sufficient amount of collateral and maintain a minimum collateral ratio.
What you do with your BAI is up to you. For example, some people use BAI to trade cryptocurrencies; others use their BAI to contribute to our stability pool.
The point is that you have options as to what you can do with your BAI.
Without further adieu, here are the concepts that you absolutely must know and that we’ll be covering today.
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- What are Collaterals, Collateral Ratios, and MCR?
- What is Instant Redemption?
- What is Instant Liquidation?
- What is Recovery Mode?
What Are Collaterals, Collateral Ratios, & Minimum Collateral Ratios (MCR)?
Some terms you will hear repeatedly are Collaterals, Collateral Ratios, and Minimum Collateral Ratios. So let’s cover these first.
What is a Collateral?
Collateral is any asset that you, as a borrower, must provide to take out a loan. The collateral acts as a security for the debt.
When you borrow BAI, you have to put up a certain amount of collateral to ensure that you will pay back the loan. This is standard in the lending world.
So far, you can use $ASTR, $BUSD, and $DAI as collateral, but we will be adding USDC and DOT soon, so make sure to look out for that!
What is a Collateral Ratio?
This is the ratio between the dollar value of the collateral in your Vault and its debt in BAI. The collateral ratio of your Vault will fluctuate over time as the price of the collateral asset changes.
You can influence the ratio by adjusting your Vault’s collateral and debt — i.e., adding more collateral or paying off some of your debt.
Here’s the simple collateral ratio formula:
Value of Collateral / Value of DebtTake DOT as a collateral example. Let’s say the current price of DOT is $30, and you decide to deposit 1,000 DOT as collateral. The value of your collateral is $30,000. If you borrow 10,000 BAI, then the collateral ratio for your Vault would be 300% ($30,000/10,000 BAI).
If you instead opt to borrow 25,000 BAI, that would put your ratio at 120%.
What is a Minimum Collateral Ratio (MCR)?
The minimum collateral ratio (MCR) is the lowest ratio of collateral to debt that will not trigger an instant liquidation under normal operations.
Different assets will have different MCRs depending on their risk profile. Usually, for stablecoins such as BUSD, USDC, DAI, etc., you will see an MCR at around 102%. On the other hand, for more volatile assets such as DOT and ETH, you will see MCRs in the 150% range.
What Are Instant Redemptions On AstridDAO?
There are two ways that BAI stays hard-pegged (i.e., follows the same price as) the U.S. Dollar. The first is through instant redemptions, and the second is through instant liquidations.
These two mechanisms give stability to our stablecoin.
- Instant Redemptions create a price floor for BAI, ensuring it never falls too far below 1 USD.
- Instant Liquidations for Vaults that fall below the MCR, on the other hand, create a price ceiling, ensuring the price never goes above 1.02 USD.
Before we go further, there’s one crucial point that I must make:
Instant Redemption and paying back your debt are two different mechanisms. To pay your debt, all you have to do is adjust your Vault’s debt and collateral. There are no additional fees.
IMPORTANT NOTE: Instant redemptions increase when the price of BAI is trading below 1 USD as it creates an arbitrage opportunity.
When there is an arbitrage opportunity, demand for BAI increases which pushes the price back up to equilibrium.
Furthermore, there is a positive correlation between instant redemptions and redemption fees.
In other words, as instant redemptions increase so do redemption fees.
This supply-side mechanism counteracts the arbitrage opportunity from the demand-side and also helps to bring equilibrium back to the price of BAI.
This is because thebaseRate increases which makes borrowing less attractive and keeps new BAI from hitting the market and driving the price below $1.
Here’s the redemption fee formula under normal operations.
(baseRate + 0.5%) * collateral drawnHere’s the arbitrage opportunity formula, assuming USD is at $1 and BAI is trading at <$1.
((USD price - BAI price) + (1 - (redemption fee))-1)*100Note: this formula ignores slippage and transaction fee. As slippage and transaction fees increase, the arbitrage opportunity decreases.
Here’s an example to illustrate how this works.
- BAI is trading at 0.99 USD, there is a 1% price difference between BAI and USD
- The baseRate = 0.1%
- The redemption fee = 0.6% (remember redemption fee = baseRate + 0.5%)
- The arbitrage opportunity = 1% (the price diff) -0.6% (the redemption fee) = 0.4% (ignoring slippage and transaction fee on exchanges)
Here’s how the arbitrage formula breaks down for this example:
Step 1: ((1 - 0.99) + (1 - (0.6% * 1)) - 1) * 100Step 2: ((0.01) + (.994) - 1) * 100Step 3: (1.004 - 1) * 100Step 4: .004 * 100 = 0.4%Step 5: 0.4% = arbitrage opportunity
There’s just one important thing I haven’t mentioned. Other people can redeem your Vault. But that’s not a bad thing.
Here’s why.
When someone instantly redeems your Vault, either in full or partially, it’s because BAI is trading below $1 and you are most likely close to the MCR.
A positive way you can look at it is when someone redeems your Vault, it’s as if someone is clearing your debt for you. You get to keep the BAI you have borrowed and the redeemer keeps your collateral.
If your Vault is redeemed against, you lose most of your collateral, but you do not incur a net loss.
As a result of you losing most of your debt exposure, your Vault’s collateral ratio will also improve (i.e., increase) after a redemption.
Furthermore, the protocol will have improved its collateral ratio, thus adding more stability.
If you want to avoid getting redeemed against, then the best way to do so is by maintaining a high collateral ratio relative to the rest of the Vaults in the system since redeemers will only redeem the vaults with lowest collateral ratio.
Remember: The riskiest Vaults (i.e., lowest collateralized Vaults) are first in line when people start redeeming Vaults.
What is Instant Liquidation on AstridDAO?
Instant Liquidation happens when the value of your assets dips below the MCR. Essentially, your collateral gets taken by either a user or by the protocol.
Anybody can liquidate a Vault as soon as it drops below the MCR of that particular collateral. The initiator receives a gas compensation (10 BAI + 0.5% of the Vault’s collateral) as a reward for this service.
If you get liquidated, you still get to keep the total amount of BAI borrowed but lose approximately the MCR minus 100% of the value.
This is why it’s critical always to keep the ratio above the minimum collateral ratio. Ideally, above 30–40% over the minimum collateral ratio.
Instant Liquidation is crucial for the health of the protocol and to keep the stability of BAI in place.
Instant Liquidation creates a price ceiling for BAI
This is because if BAI is ever trading above 1 USD (i.e., 1.1 USD), then people can swap 1 BAI with 1.1 BUSD, and deposit 1.1 BUSD to get 1.1 / 102% = 1.078 BAI, and so on and on to arbitrage.
With MCR set to 102% for most stablecoins (i.e. BUSD, USDC, DAI, USDT), then we are guaranteed that BAI is capped at $1.02.
What is Recovery Mode on AstridDAO?
Recovery Mode kicks in when the system’s Total Collateral Ratio (TCR) falls below a certain threshold (i.e.,150% for DOT).
Total Collateral Ratio (TCR) is the dollar value ratio of the entire system collateral to the system as the whole debt.
Simply put, it’s the sum of the collateral of all the Vaults expressed in USD, divided by the debt of all Vaults expressed in BAI.
Here’s the formula:
Total value of collateral expressed in USD / Total debt value expressed in BAIDuring Recovery Mode, Vaults with a collateral ratio below the recovery mode threshold can be liquidated. Moreover, the system blocks borrower transactions that would further decrease the TCR.
New BAI may only be issued by adjusting existing Vaults to improve their collateral ratio or by opening a new Vault with a collateral ratio larger than the recovery mode threshold.
If an existing Vault’s adjustment reduces its collateral ratio, the transaction executes only if the resulting TCR is above the recovery mode threshold.
Recovery mode starts when the Total Collateral Ratio of the entire system falls below a certain threshold. It’s when the protocol starts liquidating undercollateralized accounts en masse.
It’s the way the system protects itself from overexposure to under-collateralized debt.
The goal of Recovery Mode is to incentivize borrowers to behave in ways that quickly raise the TCR back above a certain threshold (i.e.150% for DOT). It’s also there to incentivize BAI holders to replenish the Stability Pool.
Economically, Recovery Mode is designed to encourage collateral top-ups and debt repayments. It also acts as a self-negating deterrent: the possibility of it occurring guides the system away from ever reaching it. Needless to say, Recovery Mode is not a desirable state for the system.
About AstridDAO
AstridDAO is a decentralized money market protocol and multi-collateral stablecoin built on Astar and the Polkadot ecosystem, allowing you to borrow $BAI, a stablecoin hard-pegged to USD against risk assets at 0% interest and minimum collateral ratio. This mechanism enables you to leverage the value in your risk assets, including $ASTR, $BTC, $ETH, and $DOT without selling them.
