The Bluejay stablecoins are backed by locked collateral tokens. The stablecoins are issued as debt by the system using collateralized debt position (CDP) - the same mechanism for issuing MakerDAO's DAI.
To mint Bluejay stablecoins, users will need to deposit collaterals like USDC, DAI, etc into the protocol to borrow the stablecoins. The amount of stablecoins allowed to be borrowed depends on the collateralization ratio of the collateral against the stablecoins as well as the current exchange rate of the tokens.
For example, if the collateralization ratio for USDC for minting of MMKT is 150% and the exchange rate for USDC to MMKT is 1:1500.
- 100 USDC will have the value of 150,000 MMKT (ie 100 * 1500)
- Maximum MMKT that can be minted is 100,000 MMKT (ie 150,000/1.5)
How is the collaterization ratio maintained?
CDP which are unable to maintain the minimum collaterization ratio will risk having their positions liquidated.
Liquidators are incentivised to help pay off the stablecoin debt to collect the underlying collaterals at a discount.
In the example above, we see a position that was safely collateralized, it has 166% collateralization ratio where the minimum should be 150%. However, due to market movement the MMKT becomes more expensive against USDC (from 1500 MMKT/USDC to 1200 MMKT/USDC), the CDP becomes under-collateralized.
When that happens, liquidators are allowed to help pay off the CDP's debt. In this case, the liquidator sends in MMKT to claim against the collateralized USDC and gets bonus USDC for the effort. The liquidator is getting 350 USDC instead of 333 USDC if he bought USDC on the market with MMKT instead. In that scenario, the liquidator made 27 USD by helping pay off the debt.
Because of the liquidation, the CDP is back in a safe position where the debt is now only 500,000 MMKT but is collateralized with 650 USDC, at a safe collateralization ratio of 156%. This also means that if the CDP creator were to pay off his debt, he only needs to pay off 500,000 MMKT instead of the original 900,000 MMKT, since part of the debt has already been paid off by the liquidator.
How is the peg maintained?
The intrinsic value of the stablecoin is determined by the following factors:
Perception of users using the stablecoin as a close substitute of the fiat currency tracked
Exchange rate fed into the protocol
Demand and supply of the tracked fiat currency
In addition to the intrinsic value of the stablecoin, the stablecoin will have a tracking error which is affected by the following factors:
Liquidity of decentralized exchanges' pools supporting the stablecoin
Keepers of the system to liquidate underwater debt positions (ie value of collateralized asset falling below safe positions)
The abundance of arbitrageurs for on-off chain arbitrages
The friction cost of converting stablecoin to tracked currency
We will explore how the peg can be maintained for both a currency with great foreign exchange infrastructure and one with poor foreign exchange infrastructure (and see how Bluejay introduces competition to reduce remittance cost over the long term).
Use Case #1 - Highly liquid market - Euro Tracker EURT
The EUR is a currency that can be easily traded to and from other major currencies with small spreads and fees.
Assuming that the EURT is more expensive than EUR against USD, an arbitrageur is incentivized to perform the following action:
Convert USD to EUR using bank transfers or payment services like Wise.
Convert EUR to EURT using an informal channel or P2P transfers like Binance P2P, possibly incurring a small fee.
Convert EURT to USDC using a decentralized exchange like Quickswap.
Convert USDC to USD using a centralized exchange like Binance, also possibly incurring a small fee.
In this manner, the arbitrageur will end off with more USD balance than when he started. When the actions are performed there is downward pressure in the price of EURT against USDT resulting in EURT being less expensive. The arbitrage opportunity will continue to exist until the gap closes between EURT/USDC and EUR/USD, likely bringing EURT/USDC to 1.2 since it's likely that the fx liquidity far exceeds that of the decentralized exchanges like Quickswap.
Should EURT becomes cheaper than EUR, a similar arbitrage opportunity will exist but the flow of money will be in the opposite direction. This creates upward pressure on the price of EURT, eventually bringing the value of EURT back on peg to EUR.
Now we will observe how the same scenario plays out in a more illiquid market with a much higher cost for exchanges:
Use Case #2 - Lower liquid market - Myanmar Kyat Tracker MMKT
The Myanmar Kyat currency is one that has limited liquidity in the global markets and has limited exchange points. There are limited bank-to-bank transfer support and no viable payment rails like Wise or Nium. Most remittance to and from Myanmar is via informal channels like the Hundi network.
In such a scenario, it is likely that the transaction fee for conversion between the fiat currency and the stablecoin to have a higher exchange fee (friction cost). We will see how that can affect the tracking error of the stablecoin.
Assuming that MMK is more expensive than MMKT, an arbitrageur is incentivized to bring the value back to peg:
However, while the rates differ by 6.25% (ie 100/1600), the friction cost is more (at 7%). In this example, we can see how an arbitrageur will fail to bring the stablecoin on peg.
While the static snapshot of the ecosystem shows that no arbitrage opportunities exist, the system is not in a stable state. Any players can enter the market to offer the swap for MMKT to MMK at a much lower rate if they:
intend to swap MMK to MMKT anyway to trade existing cash for other assets like USDC, DAI or other assets, or
intend to pay off the existing CDP position if they have minted MMKT with USDC since it is cheaper to repay the debt now, or
have confidence that MMKT will return to peg in the future
Since any player in the market can unilaterally offer a cheaper swap between MMK and MMKT, the competition between the players will drive the swap fees down. Now imagine the same situation again with lower swap fees:
There is now an opportunity for the arbitrageur to perform the arbitrage where MMK is sold for MMKT (via USDC) until the MMKT/USDC value matches MMK/USDC.