Insurance Fund

Rationale

As we have seen, the value of collateral reserves can fluctuate with movements in interest rates. Government bonds are generally considered risk-free assets, and their capital is typically repaid in full at maturity. However, when interest rates increase, stablecoins can experience temporary undercollateralization before the bond reaches maturity. Nonetheless, this undercollateralization can be offset by the interest income received on a daily basis.

In the unlikely event that a situation arises where everyone wants to redeem stablecoins and there is a small undercollateralization caused by market movements, it may not be possible to redeem 1 USD0 for exactly $1 worth of collateral. To mitigate this risk, Usual has implemented several measures. As previously presented in the risk policy document, Usual’s collateral is invested in short duration funds. This reduces the exposure to interest rate fluctuations. Additionally, Usual has established a segregated insurance fund specifically designed to protect against such events. This fund acts as a buffer to cover potential undercollateralization.

Calculation and Insurance Fund Calibration

To ensure robustness against severe financial shocks, Usual conducted comprehensive stress tests, simulating extreme interest rate rises that surpass any recorded in the last 30 years. This rigorous testing enables Usual to prepare effectively for potential worst-case scenarios.

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

• A 75 basis point (bps) rise over a two-week period.

• A 100 bps increase over a one-month period, both observed in 2022.

Given that Usual's portfolio has a maximum average duration of 0.33 years, a recurrence of these historical extremes could temporarily reduce the collateral value by approximately 0.33%. This reduction would primarily affect the portfolio's mark-to-market value for a few months.

Setting and Maintaining the Insurance Fund

The insurance fund is specifically sized to cover such tail risk events, ensuring that even in extreme conditions, the fund can mitigate losses without jeopardizing the stablecoin's stability. Practically, the aim is to maintain the fund at a level exceeding the calculated minimum requirement.

Revenue generated by the protocol is allocated to replenish the insurance fund. For 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.

Monitoring of the Insurance Fund

To ensure adequate coverage, the insurance fund's size will be periodically computed, taking into account the duration of the underlying risk-weighted assets. The funding of the insurance fund is facilitated through a smart contract, such that the DAO manages the flow of USD0 from the DAO reserves if the existing funds are insufficient.