Introduction
Collateralized stablecoins have become a crucial innovation in the world of decentralized finance (DeFi), offering users a way to utilize stable assets while interacting on decentralized networks. FXD on the XinFin (XDC) network is one such stablecoin, minted by locking XDC as collateral. However, there are economic risks associated with this system, particularly the potential creation of a dangerous credit bubble.
Current Minting Mechanism and Leverage
When XDC is locked as collateral, users can mint FXD stablecoins equivalent to the collateral provided. For instance, if you have $200 worth of FXD, you can use $100 of it to buy 100 XDC and then use these XDC as collateral to mint more FXD. This process can be repeated recursively, creating multiple layers of leverage. Each time more FXD is minted, additional XDC is purchased and locked again as collateral to mint even more FXD.
Economic Risks
While FXD is described as overcollateralized (backed by collateral greater than 100% of the stable value), this recursive leveraging process poses significant economic risks:
- Excessive Leverage: Using the same asset (XDC) repeatedly as collateral creates high leverage, which greatly increases the system’s risk. If the value of XDC suddenly drops, this can trigger a cascade of liquidations, where the system is forced to sell collateral to cover the losses.
- Depleting Actual Collateralization: The recursive leveraging process effectively reduces the actual level of collateralization supporting FXD. Although FXD appears overcollateralized on the surface, the repeated use of the same collateral weakens this security.
- Overreliance on XDC Value: With increasing leverage, the system becomes extremely sensitive to any decline in XDC’s value. A sharp decrease in XDC prices could result in a domino effect, potentially leading to the collapse of the entire system.
- Potential for a Credit Bubble: This recursive leveraging mechanism could lead to the formation of a credit bubble, where each new round of FXD minting inflates the system further. If this bubble bursts, it could result in a significant drop in FXD’s value, threatening the stability of the network.
Conclusion and Recommendations
Without strict limitations and controls, this system risks creating a serious credit bubble. Therefore, it is necessary to implement measures to restrict excessive leveraging and recursive collateralization. It is essential to:
- Introduce caps on the number of times XDC can be reused as collateral for minting FXD.
- Employ dynamic mechanisms to monitor and adjust collateral values.
- Strengthen protection against cascading liquidations that could crash the market.
By preventing excessive leverage and ensuring true collateralization, the stability of FXD as a secure stablecoin can be maintained.
References
This information is based on an analysis of FXD minting mechanisms using XDC as collateral and the risks observed in recursive collateral usage in DeFi networks.