Hedging Mechanism
We explain the theory behind our stablecoins in previous parts; in this section, we explain how our hedging mechanism works in reality.
Last updated
We explain the theory behind our stablecoins in previous parts; in this section, we explain how our hedging mechanism works in reality.
Last updated
As Drift Protocol allows us to use jitoSOL as collateral, for $100 of minted USS/eUSS, we can stake $100 to earn jitoSOL and use this $100 of jitoSOL as collateral for our short position. This helps us use users' capital most efficiently.
Here is how our stablecoin mechanism operates when SOL price increases by 10%:
Explanation:
For illustrative purpose, we assume SOL price = jitoSOL price = $100.
When users mint $1000 USS/eUSS, we stake $1000 with Jito and receive 10 jitoSOL.
We use 10 jitoSOL as collateral to short 10 SOL/perpetual contracts on Drift.
When SOL price goes up to $110, our 10 jitoSOL (and thus the collateral) is worth $1,100.
The short position size is now $1,100. We incurred a loss of $100 in our short position.
Drift Protocol requires 20% maintenance margin so the required margin is $220.
Equity in our current position is still $1,000 (equity = collateral + PnL). This means if we liquidate everything, we still have $1,000 in value. Therefore, our stablecoins value remain stable.
In our example, our short position equity always remains at $1,000. Therefore, if our short position size exceeds $5,000, or SOL price increases more than 5x, our position will be liquidated. For example, when SOL price increases by 6x:
When this happens, our required maintenance margin is $1,200, while we only have $1,000 in equity. Therefore, our position will get liquidated. When our positions get liquidated, we do not necessarily incur substantial loss. However, we need to reduce our short position size before SOL price exceeds 5x:
We can reduce our short position size when we get margin call by the exchange, but this can be quite risky because the exchange can liquidate our position before we our theoretical maintenance margin exceeds our equity due to fees. We do not want to incur these unnecessary fees.
Therefore, to leave buffer room, we start rewinding our position when the required margin exceeds 60% of the equity in our short position. When we rebalance our positions ahead, we will not incur liquidation fees.
This is equivanlent to we internally have a 67% margin requirement.
For example, this is how our protocol rebalances our position:
Explanation:
When SOL price increases by 4x, we incur $3,000 of unrealized loss, while our collateral value and short position size increase to $4,000.
A short position size of $4,000 requires $800 in maintenance margin.
This already exceeds 60% of our equity ($1,000)
So, the mechanism immediately rebalances the position:
The protocol sells 2.5 jitoSOL collateral and reduce short position size to 7.5 SOL. A short position of 7.5 SOL is equivalent to $3,000.
At the position size of $3,000, the required maintenance margin is $600--60% of our short position equity.
The $1,000 proceeds from selling jitoSOL is used to pay down the unrealized PnL. Unrealized Loss is now at $2,000.
Throughout this process, our portfolio value stays constant at $1,000.
This is way ahead of when the exchange might liquidate our position.
The case of SOL price decreasing is very similar to when price increases. It is simpler when SOL price decreases because we do not get margin call.
jitoSOL holders receive staking yield from Jito by jitoSOL increasing in price relatively to SOL. Because the long position of our protocol holds jitoSOL, This leads to the increase in underlying asset value of USS/eUSS tokens. The protocol returns yield to users by increasing the price of USS/eUSS:
Explanation:
When the protocol earns yield from Jito, the price of jitoSOL increases relative to SOL. In this example, both SOL and jitoSOL prices increase, but jitoSOL price increases more.
The effect on short position PnL is similar as the parts above.
The total equity and system value increases from $1,000 to $1,050 because each jitoSOL is worth $5 more than SOL.
This increased portfolio value is spread to all USS/eUSS holders by increasing the USS/eUSS price.
This is very similar to when the tokens earn staking yield:
Similar to other exchanges, when we open a short position with Drift Protocol, the exchange requires a . This means the equity of our short position needs to be at least 20% of the short position size.
