Collateral Risk Management

Risk Management Practices

Chi Protocol is designed to automatically manage the volatility exposure of its underlying collateral, which includes ETH, LSTs, and LRTs. This is achieved by distributing the volatility risk across various protocol stakeholders, with different tranches representing varying levels of risk:

1) USC Holders (Most Senior Tranche, Lowest Risk):

This tranche has the least exposure to volatility and is occupied by USC holders. These stakeholders benefit from the protocol’s highest level of security and stability, with their holdings being the most protected.

2) Reserve Fund (Mezzanine Tranche, Moderate Risk):

The reserve fund acts as the second tranche and absorbs moderate volatility risk. It serves as a buffer, helping to stabilise the protocol by covering potential liquidity shortfalls and maintaining collateralisation levels. The reserve fund plays a critical role in preserving the overall solvency and stability of the protocol.

3) CHI/ETH LP Stakers (Junior Tranche, Higher Risk):

The CHI/ETH LP stakers fall into the junior tranche, taking on a higher level of risk in exchange for substantial rewards. These stakeholders are exposed to greater volatility in the protocol’s collateral but are compensated with higher rewards, reflecting their risk position.

4) Protocol Itself (Most Junior Tranche, Highest Risk):

The protocol itself occupies the last tranche, bearing the highest level of risk. It benefits from the appreciation in the price of ETH, gaining extra liquidity as ETH value rises. However, it is also the first to lose liquidity when ETH prices fall. This tranche is the most exposed to volatility, making the protocol both a potential beneficiary of market gains and the primary absorber of market downturns.

Tranche Model

By structuring risk and rewards in this way, Chi Protocol ensures that volatility is effectively managed, providing stability for the most risk-averse participants while offering significant upside potential for those willing to take on more risk.

USC (Senior Debt)

USC holds the highest priority in the repayment order. In the unlikely event that the protocol defaults on its obligations, USC token holders are the first to be repaid by the protocol's reserves. USC is also the most secure asset within the protocol. Its security is derived from the collateral backing it, which includes ETH, LSTs, and LRTs, as well as the dual stability mechanism that ensures its value remains stable at $1.

As of today's date, Chi Protocol has never defaulted on its debt obligations. This track record has been made possible by maintaining persistent 1:1 collateralisation levels and ensuring USC's stability at $1, reflecting the protocol's robust design and effective risk management.

More on DSM More on USC Analytics More on Bad Debt Risks

Reserve Fund (Mezzanine Tranche)

The reserve acts as a last-loss absorber in the protocol. In scenarios where the CHI/ETH liquidity is insufficient to cover a potential deficit, the USC in the reserve fund is burnt. Additionally, the protocol uses ETH, LSTs, and LRTs from the reserves to buy back USC from the open market and burn it, thereby reducing the circulating supply. The reserve fund is financed through the protocol's internal mechanisms, including arbitrage revenue generated by the Dual Stability Mechanism (DSM), mint/redeem fees, and a portion of the yield generated by the LSTs and LRTs within the protocol's reserves. This financing ensures that the reserve fund remains robust and capable of absorbing losses to maintain the stability and integrity of the protocol.

Reserve Fund Action

When the USC in the arbitrage contract and the ETH liquidity in the CHI/ETH pool are not sufficient to cover the protocol's reserve deficit, the USC from the reserve fund is rewarded to the arbitrage contract and burnt to maintain the system's solvency.

Effect

This action helps restore the protocol's balance by reducing the circulating supply of USC, ensuring that the total supply is fully backed by the protocol's reserves. By burning the USC held in the reserve fund, the protocol can retain its 1:1 collateralisation levels, thereby reinforcing the stability and solvency of the system.

Example

Assume the protocol's reserves are worth $1,000,000, while the USC market cap is $1,100,000. If the USC in the arbitrage contract and the ETH liquidity in the CHI/ETH pool are not sufficient to cover the $100,000 deficit, the reserve fund steps in. In this scenario, the reserve fund performs a direct market intervention by rewarding and burning $100,000 worth of USC directly from the reserve fund-owned USC to restore the 1:1 collateral ratio.

This action ensures that the protocol remains solvent and that the USC supply is appropriately collateralised, maintaining the stability of the system.

More on Reserve Fund

CHI/ETH Liquidity (Second Order Junior Tranche)

The CHI/ETH liquidity pool acts as a second-order junior tranche, positioned senior to the protocol itself but junior to the reserve fund. By staking CHI/ETH LP tokens, users earn stETH and weETH rewards generated from the stablecoin reserves, with 80% of the reserves' yield currently distributed to CHI/ETH LP stakers. In scenarios where the protocol's deficit cannot be resolved by burning USC in the arbitrage contract (Protocol Tranche), new CHI tokens are minted and exchanged for ETH, which is added to the reserves. This mechanism strengthens the reserves, ensuring the protocol remains solvent and capable of maintaining the stability of USC, even under adverse market conditions.

LP Rewards

CHI/ETH LP Staking Rewards

CHI/ETH LP stakers are rewarded with the highest percentage of LST and LRT rewards derived from the protocol's reserves. As the USC market cap grows, CHI/ETH LPs are exposed to increased risks from potential downward price movements of ETH. In scenarios where there is no USC in the arbitrage contract to burn, CHI/ETH LPs might face impermanent loss. To compensate for this risk, they receive the highest yields from the protocol.

Providing liquidity in CHI/ETH not only offers high rewards but also allows users to benefit from the growth in the protocol's reserves. As the Total Value Locked (TVL) increases, so do the incentives for providing liquidity in CHI/ETH, offering both substantial rewards and a level of predictability for users' positions.

Example Suppose the protocol's reserves are worth $5 million today, with an average annual yield of 3% from the protocol's LSTs and LRTs, and 80% of this yield is allocated to CHI/ETH LPs. This results in the protocol generating $150,000 in yearly rewards from the USC reserves, of which $120,000 is distributed to CHI/ETH LPs.

Now, assume that 6 months have passed and the reserves have grown to $10 million, while the average annual yield and the CHI/ETH rewards allocation remain the same. In this scenario, the protocol is now generating $300,000 in yearly rewards from the USC reserves, with $240,000 distributed to CHI/ETH LPs.

This example illustrates how CHI/ETH LP stakers benefit from both the yield generated by the protocol and the growth in the protocol's reserves, making it a rewarding but risk-conscious strategy.

At $1 and In Deficit

At $1 and Deficit Reserves (Insolvency State)

Arbitrage Contract Action

When the reserves are in deficit and USC is trading at $1, the USC that was previously deposited in the arbitrage contract is burnt. If there is no USC left in the arbitrage contract to burn, CHI is minted and exchanged for ETH to cover the deficit.

Effect

This action helps restore the protocol's balance by ensuring that the total supply of USC remains fully backed by the protocol's reserves. By minting CHI and exchanging it for ETH, the protocol increases its reserves, maintaining the 1:1 collateral ratio and reinforcing the stability of the USC market cap.

Example

Suppose the protocol's reserves are worth $4.9 million, while the amount of USC in circulation is $5 million. If there is no USC in the arbitrage contract to burn, the protocol mints approximately $100,000 worth of CHI, exchanges it for ETH, and then adds the ETH to the reserves.

This action ensures that the protocol retains the necessary collateralisation, aligning the reserve value with the total USC supply and maintaining the stability of the system

Protocol (First Order Junior Tranche)

In scenarios where the price of ETH rises, the protocol mints new USC to maintain the 1:1 collateral ratio against the protocol's reserves. The newly issued USC is deposited within the arbitrage contract, serving as the first layer of defense against potential declines in the price of ETH. This arrangement allows the protocol to absorb initial losses by reducing the circulating USC, thus helping to stabilise the system when the price of ETH falls. As the first order junior tranche, the protocol takes on the immediate impact of market fluctuations, protecting more senior stakeholders from volatility.

At $1 and in Excess

At $1 and Excess Reserves

Arbitrage Contract Action When the reserves are in excess, and USC is trading at $1, new USC is automatically minted and deposited into the arbitrage contract.

Effect This action helps maintain the protocol's balance by utilising the excess reserves and preparing the system to handle future market fluctuations. The deposited USC acts as a buffer, ensuring that the protocol remains stable and ready to defend against any potential volatility in the value of ETH or other underlying assets.

Example Suppose the protocol's reserves are worth $5 million, while the amount of USC in circulation is $4.9 million. To maintain the 1:1 collateral ratio, the protocol automatically mints $100,000 worth of USC. This newly minted USC is then deposited into the arbitrage contract.

This action ensures that the total USC supply is fully backed by the protocol's reserves, keeping the system balanced and prepared to manage any potential changes in market conditions.

At $1 and in Deficit (1)

At $1 and Deficit Reserves (Solvency State)

Arbitrage Contract Action

When the reserves are in deficit, and USC is trading at $1, the USC that was previously deposited in the arbitrage contract is burnt.

Effect

This action helps restore the protocol's balance by reducing the circulating supply of USC, ensuring that the total supply is once again fully backed by the reserves. By burning USC from the arbitrage contract, the protocol adjusts to the deficit, maintaining the 1:1 collateral ratio and reinforcing the stability of the system.

Example

Suppose the protocol's reserves are worth $4.9 million, while the amount of USC in circulation is $5 million. To match the 1:1 collateral ratio, the protocol automatically burns $100,000 worth of USC from the arbitrage contract.

This action reduces the total USC supply, aligning it with the current reserve value and maintaining the necessary collateralization to manage future market conditions.