One of our primary goals and design principles in the Celo ecosystem is to minimize the risk for vulnerable stablecoin end-users. That is to transfer as much risk as possible from stablecoin users to the reserve and ultimately CELO holders.
Celo stablecoins are one of the if not the safest crypto stablecoins available, mainly due to the high level of over-collaterization from diversified assets. As I’m writing this, there are ~150 million USD in stables outstanding, backed by ~215 million USD of non-CELO assets and ~330 million USD of CELO, resulting in an over-collaterization ratio of ~3.8. And this after last week’s crypto market turmoil. Even if CELO alone would go to zero, all stablecoin users could still redeem their funds. Over the next few years, an increase in the allocation of natural assets in the reserve will further strengthen the stability, especially in times of crisis.
Our margins of safety are high, but the past week has shown how things can change. Maybe there are ways we can increase the robustness & reliability of the protocol in worst-case scenarios even more. With worst-case scenarios I mean a possible loss of funds to stablecoin users by heavy under-collaterization and bank-run like scenarios.
The core questions I am asking myself are what can happen should the reserve become under-collaterized? Is the protocol well prepared for different scenarios? Is there anything else we can add to the protocol to make sure that stablecoin users don’t lose in that case?
Some other protocols have emergency seigniorage token minting mechanisms in case of shortfall events or under-collaterization built into their protocol. Examples would be Maker MKR or AAVE.
I’d like to kick off the discussion whether we want to have and should start developing such a feature ourselves. I would understand such a feature as a mechanism of last resort: If the stability protocol would be about to fail, or to reduce the chances of even running into such a scenario, the protocol could borrow from it’s future value to try to survive.
What could an emergency mechanism look like? In case of under-collaterization, it would allow the protocol to mint CELO tokens and send them to the reserve. It could basically refinance the reserve by diluting or even hyper-diluting CELO.
Trade-offs
There are a couple of advantages. If well designed, such a feature has the potential to prevent under-collaterization & bank-run like scenarios by creating trust that the stability protocol has a last resort mechanism for such difficult situations. Also it could prevent loss of funds of stablecoin users by mindfully borrowing off from the future and paying back later.
But as with everything, there are risks. If poorly designed, last resort minting could reinforce negative market dynamics, creating feedback loops which worsen the damage to the protocol compared to just sitting crisis scenarios out. Designing such a feature would be a bit about timing a market crisis well, which is hard. If there is already a large supply & demand imbalance in markets and CELO is crashing, such a feature could reinforce this. The only case of such minting in the real world I know of was Iron finance. And well, that didn’t go well.
Would love everybody’s thoughts and perspectives on this.