Insights

The Million-Sat Question: What Is the Stability Pool APY?

May 16, 2023
6
min read

Finally an Answer

I regularly hear people ask—“What is the stability pool APY?” The community managers and I tend to fumble around trying to answer that question because the gains are sporadic. It has been difficult to put a number to something so sporadic. But now I have a ready answer! The answer is—at least 5% APY and possibly a lot more.

Why do I have a new answer? Because Sovryn has just added SOV rewards to the stability pool. Rewards pay 5% APR in liquid SOV on all deposits. This can be compounded if you claim your accumulated SOV and reinvest, resulting in a 5.13% APY. Not only that, but you can also stake the SOV you earn and receive revenue from protocol fees at a current 28% APR!

Possibly a Lot More

To understand why I say the APY is “possibly a lot more,” you have to understand how the stability pool works. Zero is a borrowing protocol that enables users to borrow against bitcoin by depositing bitcoin collateral and then borrowing DLLR, a USD stablecoin, at 0% interest. The bitcoin collateral must maintain at least 110% of the value of the loan denominated in USD. If the market value of the collateral falls below 110% of the borrowed DLLR, the stability pool steps in and liquidates the loan. It does this by paying off the loan in full from pool funds and claiming the entire bitcoin collateral. Since this happens when the collateral value falls below 110%, stability pool participants are able to claim bitcoin when it is worth nearly 110% of the DLLR value they pay for it. This typically results in bitcoin being purchased at an 8-9% discount. The bitcoin can then be HODLed or sold at a profit.

Why the Answer Is Hard

Liquidations can be very lucrative. A sudden 9% gain is remarkable, and it can happen multiple times in short order. We just can’t say exactly when or how often. Borrowers are typically smart, and they don’t want to lose their bitcoin in a liquidation. So they will usually monitor their collateral ratio to make sure it stays safely above 110%. But sometimes the market can sneak up on us all and take a sharp plunge. Occasionally, borrowers will underestimate the buffer needed to keep their collateral safe, and even a small dip in price can cause a liquidation. It is difficult to predict when and how often these situations will occur because it involves predicting the market and predicting borrower behavior. This is why a strong stability pool is important. It stands ready at all times to protect the solvency of the system as a whole.

To understand the challenge here, consider the liquidation behavior of Liquity since its inception in April 2021. Zero was forked from Liquity on Ethereum. They are essentially the same protocol in terms of liquidations and stability pool function, and Liquity gives us a longer track record. This plot shows liquidation APY by month. As you can see, some months were utterly boring while others were amazingly profitable.

As you can see, if you had invested in the stability pool in June 2021, your experience for several months would’ve been only slightly more exciting than watching grass grow. However, if you had held out through January 2022 or even June 2022, you would have been richly rewarded.

BE THE FIRST TO USE ZERO

Thank you! Your submission has been received!
Oops! Something went wrong while submitting the form.

Attempting to Quantify “A Lot More”

Historical behavior can sometimes give us a rough idea of how a system works and what we can expect going forward. Unfortunately, Zero is less than a year old, and the market action during this period has been relatively tame. Because Liquity is over two years old and has seen a wider variety of market conditions, I recently did two studies based on using Liquity as a proxy for Zero. I came up with some very interesting numbers.

The first study, "Fishing for Gains in the Zero Stability Pool", was quite simple. I looked at liquidation profits for 2022 relative to the total supply of the Liquity stablecoin LUSD. Expressing profits this way allowed me to normalize for the overall size difference of Liquity compared to Zero. Also, since stability pool profits get diluted by the amount in the stability pool, I could adjust the figures based on current utilization of the stability pool relative to total supply. I calculated an equivalent return for Zero for 2022 assuming users would have behaved as they did on Liquity during the same time frame. Crunching these numbers I found that the profit to the stability pool in 2022 would have been 93% for the year based on the current 6.3% utilization of the stability pool relative to supply.

A Deeper Dive

That result was only for one year. I wanted to look at the hypothetical performance over multiple years and different market conditions. Since Liquity has only been operating since April 2021, I needed a model of user behavior I could extend back and apply to historical market data.

In “Fishing for Gains in the Zero Stability Pool: Logistic Regression Analysis” I used the existing liquidation data to characterize user behavior in terms of the probability of a liquidation under various market conditions. Then I applied this model to historical price data to create randomly generated liquidation behaviors based on the probability model. I came up with the following profit distributions for each year.

The box for each year shows where the middle half of the profit estimates fell. The extreme bars show the range. Note that these percentages are relative to total stablecoin supply. They should be multiplied by 1/6.345% = 15.8 to account for the current size of the Zero stability pool. You can see that the profits vary quite a bit, not only from one year to the next but over randomly generated examples within a year using the same probability model. However, the overall results show an average year having a 130% gain based on the current 6.3% utilization of the stability pool relative to supply.

For a completely different stability pool strategy and return analysis, you should also take a look at SovereignOrigin’s “Swimming in the Stability Pool: Part 1”.

There Has to Be a Catch

These numbers look too good to be true, and we all know what to think when we see numbers that look like that. So there has to be a catch, right? Well, maybe. Here are some things I can think of.

First, Zero has had a lot of redemptions in its early days. Because of that, there aren’t many (or any) lines of credit in immediate danger of liquidation. But we’ve seen the bitcoin rollercoaster, and we know that could change quickly. New users may also come in and set up a loan with a low collateral ratio and get liquidated. (This has already happened recently.) In the meantime, a 5% yield is a pretty good deal for returns while self-custodying a decentralized bitcoin-backed stablecoin away from the clutches of manipulative government officials and incompetent banks.

Second, these returns are only models, with a number of assumptions. We have no guarantee that the future will be like the past. Or that we even characterized the underlying past process accurately in this model.

Third, in any defi setting, an exploit is always a possibility. Neither Zero nor Liquity have had any issues, and the growing time they’ve both experienced without issue breeds confidence. But there are no iron-clad guarantees.

Fourth, the stability pool has some potential for market risk if you consider holding bitcoin a risk. (It also has risk if you consider holding USD risky because the stablecoin balance is held in a USD-pegged asset.) If a liquidation occurs, your stablecoin is converted to bitcoin, and you now have market exposure to bitcoin. It is possible that bitcoin goes into a sharp decline and you’re unable to sell immediately after the liquidation. This is a real but relatively small risk historically. We looked into this risk in some detail in “Catching a Falling Knife: Zero Collateral Ratio and Stability Pool Decisions.” We considered an 8% drop during the day to trigger a liquidation and then looked at what happened after the 8% drop to the close on the same day. The results for all the times this happened in the bitcoin price since 2016 are shown below. Any bin below 92% represents a loss between the liquidation and the close.

As you can see, sometimes a large drop that triggers a liquidation is followed by a further drop. However, on average a large drop is usually followed by a partial recovery. Remember also that when a liquidation happens, the position instantly has around a 9% profit, so the price must fall another 9% before an actual loss is sustained at the close.

Stability pool depositors need to be aware of this risk and weigh it appropriately.

Go Fishing

With SOV rewards the stability pool has a new base rate. That rate compares favorably with most interest rates anywhere. So while you’re sitting around watching the paint dry and the grass grow, waiting for liquidation rewards, now you will be earning a solid 5% while you wait. You may or may not experience the kinds of gains suggested by historical analysis and modeling. Even so, you should have a better idea now what the possibilities and risks are. But the only way you’ll benefit from the stability pool going forward is to go fishing.

Remember that past performance is no guarantee of future results.

OneDigit

socials
learn more

Take your sovereignty to the next level

The road to financial self-sovereignty is long. Take a step in the right direction.