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Liquidations & stability pool
In a typical crypto-collateralised stablecoin system, users must use the stablecoin to buy up collateral to liquidate another position. While this is generally acceptable, the stablecoin can lose peg if the collateral price decreases sharply.
Hedge aims to preemptively secure the USH required for liquidation by offering a USH stability pool. Users can deposit USH in the pool and receive profits from liquidated vaults, where the profit is denominated in the collateral and is a result of buying the collateral at a market discount.
Since there are users already ready to buy collateral with USH, the stability pool helps avoid a spike in the price of USH in a market downturn. As a result, users with loans will be able to pay back their debts without paying a premium to obtain USH. The stability pool also allows for lower overall collateral requirements for vaults by helping ensure that there is USH available to buy vaults at low collateral ratios.
Whenever a vault is below its maintenance collateral ratio (110%) it is considered at risk.
A user initiates the liquidation, then USH from the stability pool is taken to pay back the USH debt (plus a protocol fee) and burnt. The remaining SOL is distributed to the users participating in the stability pool, who make a profit since the value of the SOL is more than the amount of USH burnt.
Example of how collateral is distributed during a liquidation.
For example, let's imagine there is a vault with 100 SOL collateral with 12,500 USH in debt. The maintenance collateral ratio is 110%. The current price of SOL is $160 so the collateral ratio is 128%. If the SOL price then falls to $136.25, the collateral ratio is now 109%. The vault is now under-collateralized, making it a candidate for liquidation.
The liquidation mechanism must be initiated by an individual user, who is rewarded 5% of the outstanding vault value. The outstanding vault value, equal to the collateral minus the debt, is $13,625 equivalent of SOL - $12,500 equivalent of USH = $1,125 or 8.26 SOL. 5% of this number is $56.25 or 0.41 SOL. In addition, there is a liquidation fee given to the Hedge protocol equal to 20% of the outstanding vault value, which is $225 or 1.65 SOL. The remaining 75% of the outstanding vault value is transferred to users in the stability pool, in proportion to how much USH they have deposited.
The end result is that 12,500 USH will be burnt from the pool and 97.94 SOL (the original 100 SOL minus the 0.41 and 1.65 SOL fees) given out as rewards. Since 97.94 SOL * $136.25 = $13,344, this represents a 6.8% return for users in the stability pool.
However, if the vault has a collateral ratio of less than 100%, the abovementioned fees do not apply. Since the outstanding vault value is negative, the liquidation initiator will instead be rewarded 1% of the total collateral. The protocol and stability pool will receive no reward in this case.
Hedge is designed to survive a sudden (< 1 hour) 50% SOL price crash with the measures described below. While this is not expected to happen, the nature of crypto markets means that Hedge must be able to quickly restore a system collateral ratio of >110%.
The first measure consists of using the funds in the stability pool to burn all the outstanding USH.
For example, at a SOL price of $100, a vault may have 10000 USH debt and have a balance of 90 SOL or $9000. In this case 10000 USH will be burnt from the stability pool (plus fees) and 90 SOL given pro-rata to all stability pool participants.
In this scenario, the stability pool participants will need to wait for SOL to appreciate above $111.11 to start making a profit since they essentially bought SOL for a premium.
Note: Debt redistributions are currently disabled.
If the stability pool is empty, Hedge uses an alternative measure which involves moving the debt from under-collateralized vaults to other vaults in better standing.
If the current state of Hedge is as follows (assuming a price of $10/SOL):
While individual vaults may have very risky positions, the entire system should remain collateralized by at least 150%. If the system falls below this ratio, it will enter recovery mode. This is done on a per-collateral basis by vault type: e.g. if SOL and BTC are both supported types of collateral for vaults, a calculation will be done separately for the collateral and debt per currency. That is, a crash in the price of BTC will not affect users with SOL vaults and vice versa.
In this mode, all vaults below the 150% collateral threshold can be liquidated, and actions that would make the system less healthy are prevented. Redemptions, taking a loan, or withdrawing collateral will not be allowed until the system exits recovery mode.