Dynamic Overcollateralization — a new model for Stablecoins backed by volatile collateral
The leading decentralised stablecoin, DAI, is facing issues due to the bulk of its collateral being composed of USDC — which as recent events have shown, is unilaterally censorable and has previously blacklisted entire protocols.
Given the importance of decentralised stablecoins, the only way forward appears to be using native crypto collateral (BTC, ETH) to back these stablecoins (as Maker DAO is discussing right at this moment). However, utilizing volatile collateral to back stables can run into collateral sufficiency issues.
To minimize risk of depegging, we’ve decided to develop a new, dynamic over-collateralization mechanism, which varies the required collateral ratio from 200% — over 600%, depending on (autonomously computed) market risk factors. This protects the coins’ stability even in the largest market corrections — and allows us to use volatile but uncensorable collateral like Bitcoin or Ether to back our stablecoins.
But let’s back up — how do collateralized stablecoins work today?
Types of Over — collateralization
DAI/RAI/ZUSD— Linear overcollateralization
In linear overcollaterlisation, the amount of required bitcoin backing each stablecoin declines linearly with an increase in bitcoin price, and rises linearly with decrease in bitcoin price. This does not in any way account for larger trends in BTC price — eg., when BTC is at an ATH, around $65,000 in 2021, even a 2x collateral ratio turned out to be insufficient. In contrast, when BTC is around $20,000 in 2022, a 1.5x collateral ratio may prove to be enough.
In linearly over-collateralized (dollar-pegged) stablecoins, the collar ratio (CR) is invariant with respect to the current BTC price. It is simply hardcoded, or potentially set by governance
CR = c
Where,
c = constant set by Stablecoin protocol. (EG. 150%, 200%).
ZBTC — Dynamic overcolateralization
ZBTC stablecoin system dynamically sets the collateral ratio to maximise protection against depegging and liquidiation. Dynamic collateral ratio adjustment based on the market conditions allows for far better collateral utilisation, as well as far higher protection from de-pegging in the event of large market corrections. In EVI DAO, the collateral ratio (CR) scales based on :
CR = c . Px / Psma
Where,
c = constant set by EVI DAO governance, Px = current BTC price
Psma = current SMA200 of BTC price
Fig 1: Dynamic vs Static Over Collateralization
During BTC bull runs, ZBTC imposes far higher capital requirements to mint ZBTC, accounting for an increased risk of a future market decline. As seen here, when BTC hit $60k in early 2021, ZBTC would require almost $300k deposit to mint $60k of ZBTC — the collateral ratio was briefly 500% due to extremely high risk in the market. Subsequently, when BTC again rallied to $60k in late 2021, collateral requirements briefly hit $220k — a 350% collateral ratio — still very high, but the assessed risk was considered lower due to sustained BTC price. This dynamic adjustment of collateral ratio allows ZBTC to effectively hedge anticipated risks caused by Bitcoin price volatility.
In contrast, the green line (linear over -collateralization) found in dollar pegged stablecoins, ignores the extreme risk of volatility at BTC ATHs, and thus remains more vulnerable to depegging due to market corrections.
In addition, for abundance of caution, the risk averseness of ZBTC protocol can be scaled by governance vote to increase the value of c. In practice we will initialise with a c value of 1.5, and then adjust based on market conditions.
Hypothetical Scenario: BTC appreciates to $95k in late 2022, then crashes to $30k in late 2023
This scenario further demonstrates the utility of dynamic over-collateralization. Here, as BTC price approaches $95k, Linear overcollateralization maintains the standard 200% collateral ratio, not mindful of the risk of future cyclic corrections. Thus, they require only 2BTC collateral to Mint $95k STABLECOINs.
Subsequently, when BTC crashes to $30k, the value of 2 BTC collateral is reduced to only $60k, yet $95k of stablecoins were issued against this collateral. The stablecoin is now underwater.
In contrast, ZBTC requires a 300% + collateral ratio in the same scenario of BTC reaching $95k. This is autonomously computed based on the deviation of the current market price from the SMA48, which is a reliable, historical indicator for upcoming market volatility. Utilising this information, ZBTC remains protected when BTC later crashes to $30k, where as linear stablecoins likely become undercollaterlised.
