How recovery mode keeps USH sufficiently collateralized
Hedge is a protocol that enables 0% interest lending based on Solana. In this article, we will discuss recovery mode, which is a way to ensure the protocol is sufficiently collateralized. Understanding how recovery mode works is important so you understand how to prepare for it in the rare event that it does occur. If you want to learn more about Hedge, take a look at this blog post.
What is recovery mode?
Recovery mode is a feature of the Hedge protocol that aims to stabilize the system in a volatile market. It happens when the collateral ratio, or the amount of collateral to debt, of a vault type drops below a certain limit. For the first type of vault, SOL-110, this ratio is 150%. It is not merely sufficient to have one vault with a low collateral ratio for the system to go into recovery mode. Instead, the system assesses the collateral ratio for the entire vault type, which is the sum of all vaults’ collateral divided by debt.
During recovery mode, certain actions that reduce a vault type’s collateral ratio, such as taking a loan, are prohibited until the system stabilizes. Generally, recovery mode should be activated infrequently, if at all.
Why does Hedge need a recovery mode?
If there were no recovery mode, the system would not be able to support an efficient distribution of capital at low collateral ratios. For example, let’s imagine that the system has an overall collateral ratio of 110% and then the price of collateral falls another 15%. In the case of an individual user’s vault, they may initially have $110 worth of collateral and 100 USH loan. If the collateral falls 15% to $93.5 equivalent, it is possible that USH would lose its peg. Since recovery mode ensures that the collateral ratio is always sufficient regardless of the price of the collateral, USH will always be sufficiently backed, thus keeping its peg.
What needs to happen for recovery mode to be triggered?
Recovery mode is triggered if the overall collateral ratio for all the vaults of a given vault type goes below a relevant threshold. In specific, there are two ways that the system can go below this ratio.
1. Many vaults created with low collateral ratios
If many vaults are created with low collateral ratios, this decreases the overall collateral ratio of the system.
Let’s say the system currently has $1500 equivalent worth of collateral and 1000 USH worth of loans. The current ratio is therefore $1500/1000 or 150%. If a new vault is opened with $500 of collateral and that person takes out a 450 USH loan, then the system now has $2000 equivalent worth of collateral and 1450 USH debt. Since this would cause the system collateral ratio to decrease to 138%, this action would be blocked as it would trigger recovery mode.
2. The price of the collateral decreases
In the case where the collateral price is less than before, the collateral ratio of all vaults also decreases even if the amount of debt is unchanged.
Let’s say the system currently has $1500 equivalent worth of collateral and 1000 USH worth of loans. The current ratio is therefore $1500/$1000 or 1.5. If the collateral falls in value 15%, the collateral is now worth $1275 while the debt amount is unchanged. Therefore, the system ratio is now 127.5%, triggering recovery mode.
Recovery mode is per vault type
As of this writing, there’s only one vault type in Hedge, but when Hedge supports vaults with different types of collateral, each type of collateral will be assessed independently. This means that some vault types could be in recovery mode while others are not.
In addition, the requirements for entering recovery mode could be different for different vault types. To protect the stability of the system, highly volatile assets may have a higher required collateral ratio while less volatile assets may have a lower ratio.
How does the system get out of recovery mode?
Once the system has reached the desired collateral ratio threshold (150% for the SOL-110 vault type), it will exit recovery mode. To ensure that this happens, the system performs actions that raise the collateral ratio, which are described below.
1. Raising the threshold for vault liquidation
When recovery mode is activated, all vaults below the collateral threshold can be liquidated. This overrides the normal ratio that is required for liquidation. In a liquidation, a user initiates the process and then the amount of USH owed is taken from the stability pool and is burned in exchange for the collateral, which is in turn distributed to the depositors. The depositors receive collateral which is below the market rate.
2. Preventing actions that would impair system health
The system also prevents actions that would further impair system health:
- Taking a loan: Increasing the debt in the system would decrease the collateral ratio, so we need to prevent this from happening in recovery mode. However, paying back loans is possible.
- Withdrawing collateral: Decreasing the collateral in the system would decrease collateral ratio, so again, it’s not something we allow in recovery mode. However, depositing additional collateral is possible.
What does this mean for me as a Hedge user?
Recovery mode should happen infrequently in the Hedge system. However, there are a few things you can do to help prevent the system from entering recovery mode, and make sure that if recovery mode is triggered, your vault is protected:
- Understand the collateral ratio that triggers recovery mode (for the current SOL-110 vault type in Hedge, it’s 150%). We want users to be well informed about the possible actions that can happen to their vaults.
- Maintain a high collateral ratio in your vault (over 150% for SOL-110 vaults).
- In practice, this means watching the price of your collateral (in this case, SOL). If the price of collateral decreases, ensure that you add more collateral to the vault or pay off part of your loan.