Dual Stability Mechanism (DSM)

Mechanics

Introduction to the DSM

The Dual Stability Mechanism (DSM) is the cornerstone of Chi Protocol, making USC the first capital-efficient stablecoin in DeFi that minimises counterparty risks without relying on centralised exchanges (CEXes) or exposing itself to censorable collateral. The DSM ensures USC's solvency and stability while generating protocol-level rewards for all stakeholders. This innovative mechanism allows USC to operate securely and efficiently, aligning with the decentralised ethos of DeFi.

Dual Stability Mechanism Scenarios

What is the DSM?

The Dual Stability Mechanism (DSM) is the integrated system that enables USC to maintain its $1 peg on external markets while preserving a 1:1 collateralisation ratio with USD against the protocol’s reserves. The DSM considers two main factors:

1. USC Price

Subject to the market demand for USC and fluctuations in the price of ETH, the market price of USC can trade in the following ways:

Above $1

State of USC Above $1

USC trades above $1 when:

1. Increased Market Demand: Users buy USC from the open market, driving up its price due to higher demand.

2. ETH Price Appreciation: The price of ETH rises, causing an imbalance in the USC/ETH liquidity pool on Uniswap (where the USD value of ETH exceeds the quantity of USC in the pool), leading to an upward pressure on USC's price.

At $1

State of USC At $1

USC trades at $1 when:

1. Stable Market Conditions: There is no significant buy or sell pressure on USC from the open market, maintaining its equilibrium.

2. ETH Price Stability: The price of ETH remains constant, and the USC/ETH liquidity pool on Uniswap is balanced, meaning the USD value of ETH equals the quantity of USC in the pool.

Below $1

State of USC Below $1

USC trades below $1 when:

1. Increased Selling Pressure: Users sell USC on the open market, driving its price down due to excess supply.

2. ETH Price Decline: The price of ETH decreases, causing an imbalance in the USC/ETH liquidity pool on Uniswap (where the USD value of ETH is less than the quantity of USC in the pool), leading to downward pressure on USC's price.

2. Reserve State

Similarly, depending on ETH price fluctuations, the reserves of the protocol can be in the following states:

Excess Reserves

State of Excess Reserves

Excess Reserves: When the price of ETH rises, the value of the protocol's reserves exceeds the total circulating supply of USC (reserveValue > uscTotalSupplyValue). This state indicates that the protocol has more collateral than necessary, providing a buffer that enhances stability.

Equilibrium Reserves

State of Equilibrium Reserves

Balanced Reserves: When the price of ETH remains stable and the value of the protocol's reserves matches the total circulating supply of USC ( reserveValue = uscTotalSupplyValue) the reserves are balanced. In this state, the protocol maintains a 1:1 collateralisation ratio, ensuring that USC is fully backed.

Deficit Reserves

State of Deficit Reserves

Deficit Reserves: When the price of ETH falls, the value of the protocol's reserves becomes less than the total circulating supply of USC (reserveValue < uscTotalSupplyValue). This state indicates a shortfall in collateral, which may require corrective actions such as reducing the supply of USC to maintain the stability and solvency of the system.

Based on the combination of market price of USC and the state of the protocol's reserves, the protocol defines and executes internal arbitrage opportunities. These scenarios create a total of nine possible arbitrage opportunities:

Above $1:

• Above $1 and Excess Reserves

• Above $1 and Equilibrium Reserves

• Above $1 and Deficit Reserves

At $1:

• At $1 and Excess Reserves

• At $1 and Deficit Reserves ( USC In Arbitrage Contract ≥ Reserves Difference )

• At $1 and Deficit Reserves (USC In Arbitrage Contract < Reserve Difference)

Below $1:

• Below $1 and Excess Reserves

• Below $1 and Equilibrium Reserves

• Below $1 and Deficit Reserves

Following the execution of the arbitrage, USC retains the peg and full collateralisation in LSTs, LRTs, and ETH in USD denomination.

Note: The delta represents the amount of USC that needs to be sold or bought back from the USC/ETH pool on Uniswap to adjust the price precisely to $1. For a deeper understanding of the mathematical logic behind delta calculation, visit our HackMD technical article: Quadratic AMM