Interest Rate Risk

Interest Rate Risk

Definition

Interest rate risk is the risk that changes in market interest rates reduce the value of USD0’s underlying collateral.

When interest rates rise, the market value of fixed-income securities (e.g., US Treasury Bills) typically falls. Their fixed cash flows become less attractive compared to newly issued, higher-yield instruments, which pushes prices down. If collateral must be liquidated before maturity during such a period, the protocol may realize capital losses.

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Impact on Usual’s Collateral

In an ideal setup, collateral would be held at a central bank to earn risk-free daily interest. Because the US Federal Reserve does not accept crypto stablecoins, Usual instead holds collateral in tokenized Real-World Assets (RWAs)—primarily US Treasury Bills and reverse repurchase agreements (overnight repos) via providers such as Hashnote USYC.

This approach exposes the collateral portfolio to interest rate movements. Usual quantifies and manages this exposure using duration, a traditional finance metric that approximates the expected percentage price change of a bond for a given change in interest rates. Longer duration = higher sensitivity to rate changes.

Example:

• A bond with a 5-year duration would decrease in value by approximately 5% if interest rates rise by 1%.

• A bond with a 0.33-year duration would decrease in value by approximately 0.33% under the same rate shock.

Because Usual restricts collateral to ultra-short-duration instruments, interest rate risk is structurally minimized.

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Historical Stress Test Context

Based on a historical review of the most extreme interest rate moves observed over the last 30 years:

Stress Scenario	Rate Increase	Period
2022 extreme (two-week window)	+75 bps	~2 weeks
2022 extreme (one-month window)	+100 bps	~1 month

With a maximum portfolio average duration of 0.33 years, even these extreme scenarios would imply a temporary collateral value decline of approximately 0.33%, which is intended to remain within the insurance fund’s capacity.

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Risk Monitoring and Management

Usual applies a three-line-of-defense framework with defined limits, monitoring, and escalation paths.

1) First Line of Mitigation: Duration Limits (Structural Constraints)

• Per-asset limit: Each accepted RWA must have a duration < 0.5 years.

• Portfolio average limit: The weighted average duration of the full collateral portfolio must not exceed 0.33 years (≈ 4 months).

• Eligibility enforcement: Any collateral that would cause the portfolio duration to exceed 0.33 years is ineligible for onboarding, regardless of other characteristics.

These hard constraints limit interest rate exposure before any operational monitoring is applied.

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2) Second Line of Mitigation: Continuous Monitoring (Detection & Alerts)

• Ongoing duration monitoring: Portfolio duration is computed as the weighted average duration of all reserve assets and monitored continuously.

• Passive deviation handling: Deviations caused by user activity (deposits/redemptions) or market-driven changes in RWA duration are tracked. A tolerance threshold of 0.25 years is allowed for minor, passive fluctuations without immediate corrective action.

• Rate monitoring: The protocol computes a daily weighted sum of collateral rates and maintains a 180-day rolling weighted average. Alerts trigger when:

  • The rolling average moves more than ±5% versus the prior day’s value.

  • The weighted average deviates by more than ±20% from SOFR on any day.

• Missing data handling: Weekend and holiday gaps are filled by carrying forward the last available business-day values to preserve continuity.

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3) Third Line of Mitigation: Corrective Measures (Response Actions)

If deviations exceed tolerated thresholds, corrective actions are initiated in increasing order of severity:

• Duration adjustment: Reduce portfolio duration by selling/redeeming higher-duration RWAs and reallocating into shorter-duration instruments.

• Withdrawal restrictions: Limit or remove an RWA from eligible collateral if its duration profile deteriorates beyond acceptable bounds.

• Insurance fund increase: Increase the insurance fund size (subject to available capital) to absorb potential losses from rate-driven collateral value declines.

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Insurance Fund Protection

Usual maintains a dedicated insurance fund per Liquid Deposit Token (LDT) to hedge against collateral losses, including those driven by interest rate movements.

Parameter	Value
Accrual rate	~20% of yield (set by DAO)
Minimum fund cap	0.33% of all USD0 LDTs
Maximum fund cap	5.33% of all USD0 LDTs
Replenishment time	~24 days (at 0.33-year avg. duration, 5% coupon)

This cap range is calibrated using historical Value-at-Risk (VaR) analysis across the most extreme interest rate environments observed over the past three decades.

The fund operates through the Counter Bank Run Mechanism (CBR), which burns LDT tokens held in reserve to increase the salvageable redemption value per outstanding token:

$$S_{LDT} = \min \left( \frac{\sum_{i=1}^n P_{Collateral_i} \times C_{Collateral_i}}{Supply_{LDT} - Insurance_{LDT}}, F_{LDT} \right)$$

If the salvageable redemption value falls below 1, the DAO can temporarily pause the minting engine and route activity through the secondary market to prioritize re-pegging.

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Multi Collateral Controller

The Multi Collateral Controller adds another layer of interest rate risk management through dynamic portfolio optimization. It computes optimal collateral weights by maximizing a risk-adjusted objective function that explicitly penalizes duration:

$$\max \left( \lambda_3 \sum_{i} w_i^* E[R_i] + \lambda_4 \sum_{i} w_i^* S_i - \lambda_1 \sum_{i} w_i^* D_i - \lambda_2 \sum_{i} w_i^* \sigma_i \right)$$

Where:

• $D_i$ is the duration of collateral type $i$

• $\lambda_1$ is the duration risk-aversion coefficient

This construction encourages the portfolio to rebalance toward lower-duration assets as duration risk rises, and it triggers automatically when the maximum weight deviation exceeds the threshold $\epsilon$.

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Future Enhancements

• Automated reallocations: Implement automatic reallocations among collateral types to preserve optimal risk-adjusted exposure and reduce manual intervention.

• Collateral aggregator/diversifier: Evolve toward a more advanced collateral management layer to improve duration and rate risk controls across an expanding set of RWA providers.

• Community governance: Using USUAL governance, the community may update duration limits, insurance fund parameters, and risk thresholds as market conditions change.

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Note on Parameters (KB Alignment)

The draft references specific thresholds and caps (e.g., duration limits, tolerances, insurance fund caps, alert thresholds). If you share the KB values, I can update this page to match them precisely while keeping GitBook-compatible markdown.