This discussion post outlines a plan to increase the capacity of the Kintsugi ecosystem, which is currently bottlenecked by the limited supply of collateral, preventing growth and blocking the exit of vaults from the system. The proposed solution is to use tokens from existing yield-generating products, such as staking derivatives, as collateral for the bridge. The short-term solutions could be to increase the ceiling for LKSM and adding vKSM and qToken as collateral. Another proposed solution for the mid-term would be adding LP tokens as collateral and more generally, any yield generating, structured product long-term.
Issue - Opportunity Costs
Kintsugi capacity is currently close to zero and blocks the growth of the ecosystem and does not allow for vaults to leave the system. While the high demand is favorable for the ecosystem, the limited supply of collateral poses an obstacle for further growth. There may be different reasons for the limited supply of collateral.
However, one of the main reasons for this being the bottleneck to the growth are the opportunity costs of vault operators. By depositing collateral such as KSM or USDT, they have to forgo the yield they would get when staking their KSM on the relay chain, depositing it into a lending protocol or providing liquidity into an AMM. Therefore, the bridge would have to compete with these other yield generating for the users capital.
Solution - General
Rather than trying to compete with the existing yield generating products, these yield generating tokens can be re-used as collateral for the bridge. While this comes with additional risks for the protocol as well as for the vault operator, it offers a sustainable solution to attract enough capital to scale the bridge efficiently.
Short Term Solutions
Increase ceiling for LKSM
Requirements/Dependencies: None, deeper liquidity for LKSM (optionally)
It could be proposed to increase the ceiling for LKSM to a higher amount to attract more capital because vault operators can re-stake their LKSM in vaults, making the operation of a vault much more capital efficient and attractive.
The current ceiling is at 55,000 LKSM (~$190,000) due to a lack of liquidity. However, this assumed that the full amount would be liquidated at once and that this would require to swap the total amount from LKSM into KSM into a stable coin or other token. These assumptions are extremely conservative and could be relaxed to allow for more capacity while simultaneously increase the risk of an under-collateralization of kBTC during extreme market events. How the assumptions could be relaxed:
- In practice there would likely be premium redeems prior to liquidations, which would reduce the amount of LKSM that would need to be liquidated in the event of further price decrease.
- Additionally not all of the collateral capacity is being used by one vault, which makes the event of a single large liquidation less likely.
- A liquidator of the seized LKSM might still redeem kBTC for LKSM despite not being able to sell LKSM for KSM at a favorable price because the liquidator could unstake the LKSM for KSM, for which he would need to wait 7 days, and hedge the KSM price risk using futures.
It is unclear though, how much of the newly created LKSM capacity would be filled up with new capital as it may happen that existing vaults would replace their existing KSM vaults with LKSM vaults.
Add vKSM as collateral
Requirements/Dependencies: DIA oracle market price feed, coingecko price feed — time: 2-3 weeks , deeper liquidity for LKSM (optionally) — time: 4-5 weeks
Apart from Acalas LKSM, Bifrost offers the same solution with their vKSM staking derivative. Under the current assumption that resulted in the LKSM ceiling of 55,000, the ceiling for vKSM would be around 2,500 vKSM (~$65,000) due to it’s lower liquidity. This is, of course, based on the same assumptions as stated above for LKSM, which could be relaxed to allow for a higher ceiling for vKSM.
Interlay team is closely working with Acala and Bifrost to improve the liquidity of both tokens to facilitate more efficient liquidations.
Add qToken as collateral
Requirements/Dependencies: Adding support for qTokens as vault collateral on the UI — time 2-3 weeks
Another restaking solution would be to add the supply tokens of Kintsugi’s/Interlay’s lending market as collateral. Users that supply tokens to the lending market receive qToken, which can be used as collateral in the lending market. E.g. if a user deposits USDT into the lending market, he receives qUSDT, which is interest bearing and can freely be transferred by the user unless he decides to lock the tokens as collateral to borrow from the lending market.
Similar to that, these qTokens could be registered as vault collateral. This could solve two issues at once:
- Bootstrap liquidity: Current vault operators might choose to deposit their tokens to the lending protocol and use the respective qTokens they receive as collateral to earn additional yield, which would help to bootstrap liquidity into the lending market
- Increase minting capacity: Assuming that users would use the existing liquidity to borrow tokens, this would also make it an attractive opportunity for new vault operators to add more minting capacity because of the re-staking / double yield mechanism
While the above solution would, in theory, also work with lend tokens of other lending protocols, allowing only qTokens from Kintsugi as collateral would (a) encourage vault operators to deposit their tokens into Kintsugis lending market rather than a competitor, (b) give the DAO more control over the parameters of the underlying (interest rate, target utilization, etc.).and (c) avoid adding additional protocol risk.
Mid Term Solution
Add LP token as collateral
Requirements/Dependencies: Adding support for LP tokens on the parachain and vault client — time: unclear
Similar to the other solutions, the bridge could also accept LP tokens as collateral. Although this would require further research and modelling of the thresholds, the value of an LP token is well defined as a function of the price and amount of the tokens in the pool. LP tokens also possess two properties that make them an interesting collateral asset:
- The value of an LP token is less volatile than a portfolio of the tokens it consists of, which is commonly known as impermanent loss (IL)
- Compared to qToken or liquid staking derivatives, LP tokens can always be redeem for their underlying tokens by the liquidator, which can then be sold if required.
However, the downside of the second property is, that liquidations could potentially dry up the liquidity of a pool, so that the ceiling for LP tokens need to be set accordingly and regularly monitored.
Long Term Solution
Apart from the existing tokens, this ‘restaking’ approach could be used with any other kind of yield generating tokens in the future. This could be any kind of structured products such as index funds, liquid crowd loan tokens etc., given there is sufficient liquidity to liquidate those tokens or a method to redeem them for the (liquid) underlyings.
This section is supposed to give an overview of the additional risks which the vaults and the protocol would bear compared to directly locking the ‘base’ token as collateral.
- Protocol risk: The risk that the protocol or parachain gets exploited or stops producing blocks.
- Depeg risk: The risk that the derivative token depreciates in value relative to the underlying. This could be due to a slashing event of the nominated validator for a liquid staking derivative. For a lending token this could be due to the default of borrowers without enough collateral to cover the loans.
- Liquidity risk: The risk of not being able to redeem the derivative token for the underlying because of high utilization of the supplied token in a lending market or due to the unstaking period of a liquid staking derivative. Generally derivative tokens also have lower liquidity on exchanges than their underlyings.
Generally speaking, the bridge would be exposed to the risks as the vault operators, although some of the risks can be mitigated to a great extent. While protocol risk is usually relatively unlikely to materialize, the effect on the price of the token that relies on the protocol in question is very severe in most cases.
The liquidity and and depeg risk can, to a certain extent, be reduced by adjusting the collateral thresholds upwards to account for the additional risk.
"Under the current assumption that resulted in the LKSM ceiling of 55,000, the ceiling for vKSM would be around 2,500 vKSM (~$65,000) due to it’s lower liquidity."
Ok so this is basically false as vKSM is the largest LSD on Kusama: vKSM as 2x more liquidity than LKSM.
This being said, yes vKSM has to be pushed as a collateral for Kintsugi vaults.
The main issue for vaults, as non super tech guy, is that you need to know how to install and run a vault.
The bottleneck is mainly due to this, because it's strictly restricted to tech guys currently.
-> we all have KSM or LKSM or vKSM.
I've got plenty of vKSM but i can't use them in Kintsugi vaults because i can't run a vault, i tried but it's beyond my tech knowledge.
A solution would be to have the pool system like DOT/KSM nomination pools or Khala nomination pools.
A vault that could be run for the community, where anyone could deposit in the vault.
So even if you add 10 or 20 new tokens as collateral, the guys running vaults will always be the same in the end, your bottleneck persists.
-> To my opinion, this is the main bottleneck issue, it's restricted to a base of users which is too small to run vaults.