Catching a Falling Knife: Zero Collateral Ratio and Stability Pool Decisions

Brought to you by onedigit

October 18, 2022

Investing with Zero is an exciting opportunity, but savvy investors will ask some crucial questions as they consider the risks and rewards.

Zero allows you to take out a 0% interest loan on your bitcoin collateral. You must maintain at least a 110% collateral ratio (CR), or your collateral will be liquidated. The loan is issued in ZUSD, a USD stablecoin. From there you can off-ramp to your bank account, buy more bitcoin to hodl, or deposit your ZUSD to the Zero stability pool.

These options—whether to take out a loan and what to do with a loan if you get one—require some understanding of the risks of the bitcoin market to make an informed decision. In this article, we look at market risks associated with Zero and aim to provide some insights.

There are other risks besides market risk. When you use smart contracts for investment purposes, you risk the possibility that the contract has a bug that causes it to behave differently than intended. This is called protocol risk. To mitigate this risk, Zero has passed multiple audits and internal reviews. In fact, Zero was forked from Liquity on Ethereum, and that protocol has been running without issue since April 2021. Even so, protocol risk is not zero. Furthermore, your private key could be stolen, or the oracle that determines liquidation price could be manipulated in some way. These are risks every investor must weigh.

Liquidation risk

One  risk to consider when taking out a Zero loan is the risk that the market price of bitcoin drops to the point where the CR falls below 110%. If that happens, you keep your borrowed ZUSD, but your collateral is liquidated and credited to the stability pool to pay off your loan. In the process, you lose 9.1% in value. (The loss from 110% to 100% is a 9.1% loss.) Not only do you lose value, but you lose your bitcoin position. This takes you out of the market and may have tax consequences due to the liquidation.

How likely are you to experience liquidation? Obviously, it depends on the initial CR of your loan. We can use the historical bitcoin price as a guide, although past market behavior does not guarantee that future market behavior will be similar. 

If you had selected a random day beginning in 2013 to take out a loan with a 200% CR and made no further adjustments, there is a 46% chance that you would’ve been liquidated at some point. 

If, instead, you used a 300% CR, the probability of liquidation drops to 17%. At a 400% CR, the probability drops to 7%.

The price of bitcoin is shown in the plot below. Each point on the teal line shows the lowest price bitcoin reaches, looking forward, from that point in time. 

The dotted line shows the future liquidation threshold for a loan with a 300% CR. This means that you would eventually be liquidated if you took out a Zero loan, with a CR of 300%, at any point where the price was above the dotted line. 

If the market had already pulled back significantly from a recent high, the probability of a future liquidation from that point is much lower. Consider a 70% pullback from the previous all-time high, which is where the price is as of the time of writing (October 2022). A 200% CR would have led to liquidation 4% of the time, but a 300% CR would have never been liquidated.

If you are considering a short-term loan, your risk of liquidation goes down as the term goes down. Another way to reduce risk is to monitor your line of credit and add collateral or pay down your loan when the CR goes down. But that may not be an option if you have already committed all your collateral or have your loan capital tied up in an illiquid purchase or investment. These are all things to consider as you decide on a collateral ratio.

Remember that past performance is no guarantee of future results.

Stability pool investment risk

The stability pool is a key part of Zero that helps maintain system solvency. It provides the source of liquidity to repay debt from liquidated lines of credit—ensuring that the total ZUSD supply always remains fully collateralized. Anyone who holds ZUSD can participate in the stability pool. If you deposit ZUSD in the stability pool, you obtain RBTC prorated to your share of ZUSD in the pool whenever a liquidation occurs. This gives you the potential to obtain RBTC valued at up to 110% of the value of the ZUSD you give up. However, that exchange means that you then have exposure to RBTC instead of ZUSD.

In a fast-moving market, it is possible that the value of the liquidated RBTC will not be as high as 10% more than the value of your ZUSD at the moment you forfeit it for the collateral. If we use the historical experience of Liquity as a guide, the collateral is typically worth about 9% more than the forfeited stablecoin by the time a liquidation occurs. The premium has been as low as around 5% on rare occasions. Generally, however, this appears to be a small risk, and there is no example of actually losing value in a liquidation.

However, the risk doesn’t end at the moment of liquidation. In fact, it starts there. Unless you are constantly monitoring your stability pool position or have programmed a bot to do it for you, your newly acquired RBTC exposes you to price variations in RBTC from that point forward. 

Liquidations are more likely to occur in a fast-moving market where the price could continue to drop steeply and rapidly. Traders often say that trying to buy in a rapidly falling market is like trying to catch a falling knife. Even though the price may well rebound and reward you handsomely, it is difficult to know when to enter a market like that. You can easily lose a finger…or a chunk of your portfolio.

The stability pool will sometimes catch a falling knife automatically. To assess the risk when this happens, we looked at historical bitcoin data where the price dropped at least 8%. We considered both hourly drops and daily drops, but the results were similar. Here we discuss 8%+ drops over 24-hour periods to represent surprise liquidations.

The chart below shows all cases since 2016 where the low fell below 92% of the opening price in a 24-hour period. The ratio of the low to the open is shown for each case over time. It is clear that bitcoin has dropped more than 8% many times. Large price drops like this are likely to catch some low-collateralized Zero borrowers off guard and trigger liquidation. It should be evident from this data that keeping the CR just above 110% may be a risky decision.

Furthermore, if the price dropped 8% from the open, it often dropped substantially more than that. In several cases, the price dropped 20% or more. If a stability pool participant received RBTC from a liquidation after an 8% drop, any drop beyond that was suffered by stability pool participants holding the liquidated RBTC.

A more important consideration than the low after a large drop is the close. What typically happens after a large drop? Is it more likely to keep dropping, delivering a loss to stability pool participants after a liquidation? Or does it tend to recover after a significant drop?

The following chart shows the closing behavior on days when the low was at least 8% below the open. Notice that any close above the 92% line is a gain for stability pool participants if liquidation occurred after an 8% drop. As you can see, sometimes there was a gain, and sometimes there wasn’t. Anyone participating in the stability pool must weigh this risk against possible gains. 

Remember that any loss in this scenario would’ve been countered by up to a 10% gain due to the liquidation premium.

If we consolidate the observations above into a histogram, we get the following distribution. As you can see, when the price dropped at least 8%, the closing price often moved considerably from that point. Considering that around a 9% gain is typical for the liquidation premium, any closing price above about 84% is actually a gain for stability pool participants. (The drop from 92% to 84% is about a 9% loss that cancels the 9% initial gain.) Notice how rarely this level of loss has happened by the closing price.

What about the average result? On average, when the price dipped below 92% of the open, the price closed at 93% of the open. That is, on average, stability pool participants actually profited after a liquidation at 92% by the time the market closed. Could this average be only the result of a few outliers? A better statistic in that case is the median, which finds the middle value after ranking all the values. The median price closed at 92.5% of the open. So based on the median statistic, the typical result was a profit for stability pool participants as well.

Summing up

Keep in mind that these are historical results, not predictions. But in the absence of the ability to predict the future, the past is all we have to learn from. History can help us adjust our Zero CR based on our general risk tolerance. A 300% CR after a 70% pullback has historically been a reliable set-and-forget strategy for borrowing. Other strategies may be appropriate for your timeframe and risk tolerance.

If you’re considering an investment in the stability pool, you have to consider a different set of risks. Liquidations mean you take on new RBTC exposure, sometimes in a volatile market. This may or may not be immediately profitable. However, the average outcome historically would’ve returned a slight profit in the same day. In the longer term, you have to decide whether to hold RBTC or swap it for a stablecoin.

Learn more about Zero, and join the waitlist.

Stay safe out there, and Stay Sovryn!

DISCLAIMER: Nothing in this article should be taken as investment advice. Inclusion of a third-party app or service does not constitute an endorsement of the app or service by Sovryn developers or anyone else in the Sovryn community, and is provided for informational purposes only. If you have any problems with the listed third-party apps or services, please contact the maintainer of that app or service for help. Sovryn does not have any control of your funds in any supported Web3 wallet -- you are responsible for your own wallet security. Please do your own research and ensure you understand and accept the risks before trading or using any apps or services to store your funds. 

You May Also Like

Leave A Reply