Introducing Leverage Interest Rate to Incentivize Parrot Stability Pool

The Parrot stablecoin PAI is over-collateralized and backed by a diversified basket of assets. Yet the price of PAI against USDC and USDT has been persistently below peg. The PAI:USDC:USDT pool reserves in the Mercurial PAI3pool and Saber’s PAI:USDC pools are badly imbalanced.

To help restore PAI’s price peg, we need to incentivize the stable swap pools to stay balanced in its proportion of PAI and USDC reserves.

TLDR;

  • Stability pools to incentivize USDC and USDT liquidity for PAI
  • PAI interest rate to rise to incentivize USDC stability pool
  • The interest rate will be determined by the imbalance ratio of PAI:USDC in a stable swap pool.
  • A stable vault may have liquidation events if accrued interest dips the collateral ratio below 100.5%
  • The leverage interest rate adjustments will start on November 22nd
  • 2 weeks grace period until stable vaults liquidation is enabled on December 7th

The approach to improve the stability of the PAI stable swap is double pronged:

  1. Introduce stability pools to specifically incentivize USDC liquidity for PAI
  2. The protocol will start charging a dynamic Leverage Interest Rate on PAI. These interests will pay the USDC depositors in the stability pools.

The Parrot Stability Pools are single sided pools for USDC. USDC deposited in the pool will be deposited in the PAI stable swap pools to earn stable swap incentives (i.e. MER and SBR rewards). In addition to that, USDC depositors will receive Leverage Interest Rate collected by the protocol on outstanding PAI debts.

Leverage Interest Rate

On top of the base interest rate that Parrot is charging (currently 0.1% per year), the protocol will introduce a dynamic interest rate to pay for the leverage that the system is creating. A farmer may use PAI as a leverage instrument in the following way:

  • Deposit 100 USDC into Saber to get 100 SBR UST-USDC LP
  • Deposit 100 SBR UST-USDC LP in Parrot to mint 99 PAI
  • Trade 99 PAI for 99 USDC from a USDC:PAI trading pair
  • Deposit 99 USDC into SBR to get 99 SBR UST-USDC LP
  • At this point, the leveraged farmer has 199 SBR LP from 100 starting USDC, nearly doubling the yield.
  • The leverage farmer can choose to repeat the leverage cycle

In essence, the USDC:PAI trading pair is providing the leverage without getting paid. If there is a fat yield opportunity through PAI, there would be a strong pressure on the USDC:PAI peg because of leverage cycles like the above to “borrow” the USDC from the USDC:PAI stable swap.

While the USDC:PAI LPs are being incentivized by fees and protocol rewards, these are not sufficient to pay for the leverage apes are putting on. Therefore, a Leverage Interest Rate is required to collect interest from leveraged PAI debts, and pay the USDC provider specifically.

In the case that the stable swap reserves are balanced, the leverage interest rate will be 0. If there is imbalance in the pool, the leverage interest rate will encourage USDC liquidity, AND discourage PAI borrowing.

If PAI’s price is below peg, the leverage interest rate will be set based on the following formula:

MAX(3 * (PAIReserve — USDReserve) / USDReserve, 0)

To illustrate how this works, here’s a table of how much the leverage interest rates would be given the amount of PAI relative to USDC in the pool:

1x 0%

2x 3%

3x 6%

4x 9%

5x 12%

6x 15%

7x 18%

8x 21%

9x 24%

10x 27%

If the amount of PAI is less or equal to USDC, then the interest rate is 0. If the amount of PAI is greater than USDC by a factor of 2, then the interest rate is 3. If the amount of PAI is 10x the amount of USDC, the interest rate would be 27%.

Once the leverage interest rate is determined, all vaults will adjust to the same target interest rate at the pace of 1% per day. So if the current rate is 0%, and an imbalance sets the leverage rate to 10%, it will take 10 days to reach that level.

Phased Introduction of Interest Rate

The introduction of leverage interest rate is a big change to Parrot’s financial design. This also introduces additional costs and risks to Parrot’s users. A phased process of introducing the interest rate will allow Parrot’s users to adjust their positions as necessary.

Interest rate complicates the stable vaults. Previously they were charged a low 0.1% interest rate, and had no possibility of liquidation. With interest rates, the following changes will be made:

  • Stable vaults liquidation penalties will be reduced to 0.1%
  • Stable vaults liquidation level will be set to 100.5%
  • 2 weeks grace period before liquidation is turned on

As borrow interests accrue, the stable vaults’s collateral ratio will slowly decrease. Stable vault users will have to manage their collateral ratio accordingly. However, vaults will have a very low liquidation penalty compared to non-stable vaults.

Self-repaying stable vaults will be introduced in the future so users won’t have to manage their positions.

Summary

The Parrot protocol is over-collateralized, and the fact that PAI, pSOL, pBTC are persistently below peg is because of “free” leverage being used, subsidized by the stable swap USDC providers.

The USDC liquidity provider needs to be paid lending interests. By joining the stability pool to provide liquidity for PAI, USDC providers will be able to collect leverage interests on outstanding PAI debts.

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