The Market Crash and What We’ve Learned at Ratio Finance
What a week it has been!
First of all, we hope that everyone reading this is doing OK. It’s a tough time for our industry, and one that truly highlights how nascent we are.
From a statistical point of view, up until just a week ago, UST was a safe haven asset for hedge funds, DAO treasuries, family offices, and individual investors. UST was a strong form of collateral that, for months on end, maintained its stability and served its purpose as an asset to hedge volatility.
We at Ratio Finance have learned a lot from this experience, and, in some ways, are grateful that we have experienced some delays. The mission of Ratio Finance has always been to De-risk Decentralized Finance. The capitulation of UST and Luna are prime examples of how lofty of a mission this is. The entire crypto industry was rocked by what was not a Black Swan event, but instead a predictable exploit that nobody thought anyone could actually pull off.
The stability of any stablecoin is based ultimately on two variables: Collateral, and Trust. The type of collateral that a stablecoin uses is of vital importance to how consistently stable that asset will be. In an updated close review of the different forms of collateral and contingent LP risks, we unearth valuable quantitative and qualitative lessons as we expand forward in our mission to De-risk DeFi.
Different types of collateral
Collateral can have many forms and thus assets can be secured by a handful of different types of collaterals. In the case of stablecoins they are typically identifiable by one of four underlying guarantees: fiat-backed, crypto-backed, commodity-backed, or algorithmic, and it is up to each issuer to freely decide the underlying compositions of their collateral.
Not all stablecoins are created equal and at the end of the day it is a comparison between assets and liabilities. For example, Circle’s assets are a collection of T-Bills and physical holdings of USD, and their liabilities are the issued USDC; whereas Terra’s assets are exogenous collateral like Bitcoin and negative equity aka LUNA and UST’s peg was supposed to be backed by redeeming and issuing LUNA at a fixed rate. A great graphic of the main USD pegged stablecoins assets and liability can be found here.
General risk lessons
- Centralization of Luna
The design of stablecoins fundamentally matters and an important component is the monetary policy. As mentioned by Catalini and de Gortari:
“There are two critical dimensions that underpin the economic design of every stablecoin: (1) the volatility of the reserve assets against the reference asset, which defines the risk profile of the stablecoin for coin holders; and (2) the degree to which the stablecoin is exposed to the risk of a death spiral.”
To address these different types of risks, fiat-backed stablecoins must rely on high-quality reserves and be subject to a foundation that protects holders from credit risk, market risk, operational risk, as well as the insolvency or bankruptcy of the issuer. Things are more complicated for decentralized stablecoins because by eliminating an intermediary the issuer is exposing the protocol to systematic risks that only high-quality over-collateralized backing can account for.
From the price action of the last couple of days it has become apparent that algorithmic stablecoins are unlikely to be able to withstand extreme market conditions. Moreover, a flawed economic design and monetary policy with high interest rates (up to 20%) was a key driver in the expanding UST issuance rather than any real utility for the coin.
- The risks of LP pool compositions
Ratio’s collateralized debt position decisively relies on the issuance of high-quality LP collateral.. The lessons learned from CASHIO to UST are multiple, however there is a common course of action:
Imagine that we have a pool composed of two assets, A and B. If there is vast sell pressure on asset A, the composition of the pool is skewed and becomes uneven. This is obvious. However in the case of systemic events, if a user wants to realize their losses by unwinding the LP position two outcomes are possible: either the user gets paid in the weaker currency which might be illiquid or the user will get paid pennies on the dollar on the stronger currency. This is an example of extreme impermanent loss that can only happen in these types of markets.
Our risk team has been primarily focused on quantitative risks associated with various forms of collateral. What has become clear is that qualitative risks, such as the founders or entities that are backing up stablecoins with collateral, are an essential component to be considered in fully assessing the risk of assets.
In order for us to safely allow users to leverage stablecoin assets, we are committed to starting the collateralization of USDr with the safest assets available. We are also committed to using the Fair Price of stablecoin LP as a guiding principle in establishing our dynamic overcollateralization ratios.
Our mainnet is set for release next week. Users will be able to mint USDr, using the safest pools on Saber. After this, the types of collateral that are accepted by Ratio Finance will rapidly grow.
We will use a gradual cap system to ensure the long-term safety and stability of USDr. Users will be able to farm USDr-USDC on Atrix to earn SRM.
Our platform is powered by Ratio Risk Ratings, our own proprietary risk oracle that will soon be made available to other platforms. If you are a DAO or Institution interested in gaining access to our Risk Ratings, please reach out to us at team@ratio.finance.
It is clearer than ever that platforms like Ratio Finance are needed to help protocols and investors make intentional decisions when it comes to the assets that they support.
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Ratio Finance’s mission is to enhance liquidity and De-Risk DeFi, to allow both retail and institutional investors to participate in these novel markets.
Our long-term vision is to be the Risk Rating Agency for all of Decentralized Finance.
