How Does SIKKA Keep its Peg?
You’ve probably heard of fiat-backed stablecoins, which are the most common type of stablecoins. USDC and USDT are two examples. These are fully backed by USD reserves and have undergone security audits. However, crypto-overcollateralized stable assets trail the fiat-backed coins. These can be said to have the same goal, but due to the volatility of the crypto collateral, a different architecture is required.
We can think of it this way. Stable assets are only stable if sufficient reserves are held against the total supply in circulation, implying that there is enough leverage to maintain the peg regardless of what the rest of the market does.
DAI, on the other hand, does something similar but with cryptocurrency. The main point remains that there is more value locked up in reserves than there are coins in circulation. The only difference is that instead of USD, the assets locked in the reserve are other cryptocurrencies. This brings up another consideration. To account for volatility, crypto reserves must be much larger than stable asset reserves so that even if the price of crypto falls, there will still be more value locked. MATIC is used as collateral by SIKKA in particular.
SIKKA is held steady by three key stability mechanisms: a 75% minimum collateralization ratio, liquidation mechanisms, and arbitrage incentives.
Correlation Between MCR and Peg Stability
The SIKKA stable asset’s over-collateralization ensures that it will never be de-pegged. This is ensured by a safeguard known as the minimum collateralization ratio (MCR). This is the smallest amount of collateral you can withdraw against your MATIC deposit. Sikka has an MCR of 75%. See the figures below for a better understanding of how this works:
Borrowed Amount: $150
Total Locked Collateral: $200
Collateral Ratio: 75%
In this case, the MCR is 75 % because $150 is 66 % of the total deposit of $200.
This serves as a peg stability mechanism because the locked collateral is always worth more than the borrowed amount. This provides the MATIC with a 25% buffer to fluctuate before the loan is at risk of being liquidated.
Two things can happen at this point:
1. The MATIC collateral is never less than the MCR, and you return the SIKKA to reclaim your original collateral.
2. Your collateral is liquidated because the MATIC falls below the threshold.
Liquidation Mechanisms as a Backstop to Falling Collateral Prices
This peg stability mechanism works in tandem with the MCRs. Because the collateralized assets are volatile cryptocurrencies, there is always the risk that their value will fall and the MCR threshold will be activated. If this occurs, liquidation mechanisms serve as a safety net to ensure that the loan’s collateral is more valuable than the loan itself. After all, it would be absurd to be able to obtain a loan that was more valuable than the currency you were locking up as collateral.
SIKKA liquidation occurs when the current worth of collateral with a safety margin is less than the borrowed amount.
As a reward for starting the liquidation, the liquidator receives gas compensation. It is an opportunity that arises during the liquidation process, and any Sikka user, including the borrower, can take advantage of it. Sikka absorbs the debt, and the sold collateral is distributed among the liquidators who participate in the auction.
Market Dynamics that Enable Peg Stability
To begin with, the peg is secure due to over-collateralization. However, high lending and borrowing volumes can cause minor (1%) changes in the price of SIKKA, leaving room for arbitrageurs to enter the picture. When users set up loans, the minting and burning process causes minor supply/demand fluctuations, causing the stable asset to move a few cents off the dollar.
“Arbitrage is the simultaneous purchase and sale of the same asset in different markets in order to profit from tiny differences in the asset’s listed price,” according to Investopedia. Simply put, if the price of a stable asset is higher on one exchange than another, someone can buy it on the cheaper market and sell it on the premium market, earning an instant yield.
Although it may appear to arbitrageurs as free money, this mechanism is what allows SIKKA’s peg stability. The disadvantage is that because SIKKA is only $1, arbitraging requires users to arbitrage hundreds of thousands of tokens to make a decent yield.
Let us not forget that the primary factor that keeps an over-collateralized stable asset pegged is the fact that the assets held in reserve are greater than the total value of the stable asset in circulation, and the MCR is what allows this to happen. Liquidation mechanisms are the backstops put in place to support the goal of MCRs. The goal is to ensure that each and every loan is over-collateralized.
Finally, minor price fluctuations in the market allow arbitrageurs to stabilize the market by buying when the price is just below the peg and selling when the price returns to the peg.
Disclaimer: Although we reference “stablecoins,” we don’t claim that these assets will always hold their peg. We call SIKKA a stable asset, reflecting that it’s over-collateralization price stability has a few days lag time.