# Insurance Fund

## Rationale

The value of the collateral reserves backing **USD0** can fluctuate with changes in interest rates. US Treasury Bills and government securities are generally considered risk-free assets and are typically repaid at par at maturity. However, when interest rates rise, the **mark-to-market** value of these instruments can temporarily decline, creating a short window of **undercollateralization** before the bonds mature. Over time, this temporary gap is naturally offset by the **daily interest income** accrued on the underlying collateral.

In the unlikely event of a **mass redemption** scenario—where many users redeem USD0 simultaneously—combined with a temporary dip in collateral value caused by market movements, it may not be possible to redeem **1 USD0 for exactly $1** worth of collateral at that moment. To mitigate this tail risk, Usual implements several protective measures:

* **Short-duration collateral**: As defined in the [risk policy](https://github.com/Pi-2lavega/usual-gitbook-sync/blob/main/resources-and-ecosystem/risk-policy/financial-risk/README.md), all collateral must maintain a **portfolio average duration below 0.33 years** (\~4 months), with **individual RWAs capped at 0.5 years**. This materially limits exposure to interest-rate fluctuations.
* **Zero tolerance for credit and FX risk**: Only **US Treasuries**, **quasi-government debt**, or **cash** are accepted—no corporate debt and no unhedged foreign-currency exposure.
* **Segregated insurance fund**: A dedicated on-chain fund designed to absorb potential undercollateralization events, acting as a buffer to protect USD0’s **1:1 peg**.

> Note: If any risk parameters, collateral requirements, or safety mechanisms have been updated in the knowledge base (KB), reflect those latest values here.

***

## Calculation and insurance fund calibration

To ensure robustness against severe financial shocks, Usual conducted stress tests simulating extreme interest-rate increases exceeding anything recorded in the last 30 years.

Historically, the most significant short-term increases in 6-month yields were:

* **+75 bps** over a two-week period (observed in 2022)
* **+100 bps** over a one-month period (observed in 2022)

Given a maximum portfolio average duration of **0.33 years**, a recurrence of these historical extremes could temporarily reduce collateral value by approximately **0.33%**. This impact primarily affects mark-to-market valuation for a few months, until the bonds mature at par.

***

## Salvageable redemption value

The insurance fund operates through the **Counter Bank Run Mechanism (CBR)**. Under the CBR, the protocol can increase the per-token backing ratio by **burning USD0 held in the insurance fund**, thereby reducing circulating supply relative to the collateral value.

The **salvageable redemption value** is calculated as:

$$
S\_{LDT} = \min \left( \frac{\sum\_{i=1}^n P\_{Collateral\_i} \times C\_{Collateral\_i}}{Supply\_{LDT} - Insurance\_{LDT}}, F\_{LDT} \right)
$$

Where:

| Variable                                       | Description                                      |
| ---------------------------------------------- | ------------------------------------------------ |
| $P\_{Collateral\_i} \times C\_{Collateral\_i}$ | Total value of collateral type $i$               |
| $Supply\_{LDT}$                                | Floating supply of USD0                          |
| $Insurance\_{LDT}$                             | USD0 set aside by the DAO for the insurance fund |
| $F\_{LDT}$                                     | Intended fair price of USD0 (i.e., $1.00)        |

By burning USD0 from the insurance fund (i.e., reducing the denominator), the protocol increases the redemption value per remaining USD0 in circulation, supporting restoration of the peg.

***

## Insurance fund sizing

The DAO sets a maximum insurance fund cap based on historical **Value-at-Risk (VAR)** analysis. The cap ranges from **0.33% to 5.33%** of all USD0 in circulation:

| Scenario                            | Cap range   | Basis                                                                                                                       |
| ----------------------------------- | ----------- | --------------------------------------------------------------------------------------------------------------------------- |
| Interest-rate shock only            | \~0.33%     | Worst-case +100 bps move with 0.33-year duration                                                                            |
| Combined with counterparty exposure | Up to 5.33% | Includes SVB-type events (referencing the \~5% USDC depeg in March 2023 when Circle had 8% exposure to Silicon Valley Bank) |

***

## Setting and maintaining the insurance fund

The insurance fund is sized to cover **tail-risk** events. Operationally, the goal is to maintain the fund **above** the calculated minimum requirement.

### Funding source

The insurance fund is funded using a portion of the yield generated by USD0’s underlying collateral. The DAO sets an **insurance accrual rate**—approximately **20%** of collateral yield—which is directed into the fund on an ongoing basis.

### Replenishment speed

Protocol revenue is allocated to replenish the insurance fund.

**Example:** With an average bond duration of **0.33 years** and a coupon rate of **5%**, it would take approximately **24 days** to replenish the insurance fund to cover potential losses from a worst-case interest-rate shock.

### Emergency measures

If the salvageable redemption value falls below 1, the DAO can take additional defensive actions:

1. **Temporarily pause the minting engine** to focus on re-pegging USD0 using existing supply.
2. **Route minting activity through the secondary market only** (no new collateral accepted until the peg is restored).
3. **Deploy the insurance fund** to burn USD0 and restore the per-token backing ratio.

***

## Monitoring the insurance fund

To ensure adequate coverage, the insurance fund size is periodically computed, taking into account the duration of underlying risk-weighted assets and current market conditions. Key monitoring parameters include:

* **Portfolio duration**: Continuously tracked to ensure the weighted average remains below **0.33 years**, with a **0.25-year tolerance** for minor fluctuations.
* **Interest-rate monitoring**: A **180-day rolling weighted average** of collateral rates is maintained. Alerts trigger when the rolling average deviates:
  * more than **±5%** from the previous day, or
  * more than **±20%** from the **SOFR** benchmark.
* **Fund adequacy**: Regular comparison of the insurance fund balance against the VAR-derived minimum requirement.

Funding and top-ups are facilitated via a smart contract, allowing the DAO to manage the flow of USD0 from DAO reserves if existing funds are insufficient. This on-chain mechanism ensures transparency: anyone can verify the current size and adequacy of the insurance fund at any time.


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