Fishing for Gains in the Zero Stability Pool

Brought to you by Onedigit

January 16, 2023

Zero enables you to borrow ZUSD—a USD-pegged stablecoin—with zero interest using BTC as collateral. The loan must be maintained at a minimum collateral ratio (collateral/debt) of 110%. If the collateral ratio falls below 110%, Zero employs a stability pool consisting of ZUSD to pay off the debt and liquidate the collateral. Simultaneously, Zero rewards stability pool providers.

The stability pool is the first line of defense in maintaining system solvency. By providing funds to liquidate low-collateralized loan positions, it ensures that the total ZUSD supply always remains fully collateralized. In exchange for this service, the stability pool receives the entire BTC collateral from a liquidated line of credit, which should ordinarily be worth 110% of the ZUSD taken from the pool to liquidate the loan.

Anyone can participate in the stability pool. You don’t have to borrow ZUSD against your bitcoin to do it. You can simply bridge in stablecoins—USDT, USDC, BUSD, or DAI—and convert it to ZUSD to deposit in the stability pool and earn liquidation gains.

Providers of ZUSD to the stability pool have the potential to earn significant gains through liquidation events while contributing to the solvency of the Zero protocol. These liquidation events are sporadic but can lead to substantial gains when they occur.

How can we assess the potential return of the stability pool? While there is no way to calculate the potential gains with any certainty, we can use historical data to give us some indication of the dynamics of the system and possible returns. The most obvious source of historical data is the track record of Zero itself.

Zero has been in operation for almost seven months (as of January 2023). In that time, several liquidations have occurred. Gains are shown in the graph below.

Profits are calculated by assuming that the liquidated BTC collateral is sold for ZUSD at the market price immediately after liquidation. From the graph we can see that liquidations have happened and stability pool participants have profited. However, this timeframe does not show any large liquidation events because the market has been relatively nonvolatile during this period.

We can get a better sense of the long-term behavior of the stability pool by looking at the activity in Liquity. Liquity is a protocol on Ethereum that allows users to borrow the LUSD stablecoin using ETH as collateral. Zero was forked from Liquity. Zero uses essentially the same mechanisms and parameters but uses BTC as collateral and issues ZUSD on Rootstock. Liquity has been running since April 2021 and has seen a much larger variety of market conditions than Zero.

We can see cumulative gains for Liquity from a Dune dashboard.

Liquity has had $34M in gains since its inception and $13.5M in 2022. Since Liquity has a much larger TVL than Zero, we need to normalize these values so we can interpret the information better in our context.

The following chart shows monthly APYs for Liquity. APYs are calculated relative to total LUSD supply, not the amount in the stability pool. We calculate APYs relative to overall supply because liquidation sizes should be proportional to the total supply, not the amount that happens to be in the stability pool. If we were to calculate APYs relative to the stability pool, they would be even higher. 

As you can see from the chart, large liquidations are quite sporadic. But the size of the gains is quite impressive when liquidations do happen. The overall APY for the past year was 5.9% relative to total LUSD supply. 

Note that the period corresponding to the time since Zero was launched has been relatively quiet. The liquidation in June occurred before Zero was launched, leaving the small bump in November as the only significant liquidation during the lifetime of Zero. This corresponds to the visibly large liquidation in November in the Zero chart. Zero has experienced a total of 16K ZUSD in gains. During the same time, Liquity has experienced 230K LUSD in gains. The relative size of the two liquidation amounts corresponds well to the TVL of each protocol. This correspondence provides some confirmation for using Liquity’s longer history to infer the hypothetical behavior of Zero during this extended time.

As it turns out, the stability pool in Zero is considerably underutilized relative to the stability pool in Liquity. Liquity subsidizes their stability pool with their protocol token, leading to much higher relative usage. In fact, Liquity has 69% of the total LUSD supply in the stability pool, while Zero has 5% of ZUSD in the stability pool. Only stability pool participants share in the liquidation gains. So similar APYs in Zero relative to total supply will be shared by a relatively much smaller stability pool and will result in much larger returns for participants. 

In Liquity, the APY relative to the stability pool size was (5.9%/69%)✕100% = 8.5%. If Zero had the same relative return as Liquity, we would expect 5.9% of the 6.5M (at the time of writing) ZUSD supply in profit, for a total of 383K ZUSD. Since the entire stability pool for Zero was only 302K ZUSD, the APY would be (383K/302K)✕100% = 127%! Keep in mind that this return corresponds to the last year, in which ETH fell 72% and BTC fell 70%. This was quite a lucrative strategy for a declining market. It likely performs better in a declining market than a rising market due to the higher likelihood of liquidations. Even so, rising markets in BTC often have significant pullbacks and can trigger large liquidations as well.

How do you participate in the stability pool? First, you must gain access to Zero, which is still in an early access period. Sign up for the waitlist and wait for an invitation to join. Once you’ve joined, bridge in some stablecoins using the Babelfish XUSD stablecoin aggregator on the portfolio page of the Sovryn dapp, if you don’t already have some XUSD. Go to the Zero dapp and convert XUSD to ZUSD. Then deposit the ZUSD to the stability pool. Remember that you may need to be patient—liquidations are very sporadic. And past performance is no guarantee of future results.

Stay Sovryn!

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