As we restore reweights and direct incentives, we should take the opportunity to make adjustments to the mechanisms based on learnings from the first week of the protocol being live before everything was paused.
FIP-2 created a price floor for FEI at $0.95, which can help range bound the peg when there are large deviations either in demand for FEI or the price of ETH.
- The spread between the burn penalty and mint reward is a “no trade zone” where traders prefer secondary markets or not trading.
- Having high potential burns makes it hard for oracles and aggregators to accurately determine the price of FEI on incentivized Uniswap pools.
- Mint rewards can occur without a sell penalty if the oracle price of ETH goes down
- Do not directly incentivize peg restoration, but rather facilitate deflation which reduces the supply
- Incentive parity is a complex trigger condition dependent on time since peg restoration, distance from peg, trading volume, and ETH volatility
- Arbitrage with a “true price” of FEI between the mint and burn prolonged the time to incentive parity
One solution to solving the issues with reweights is to have them occur regularly with a predetermined time interval of every few hours for example. This allows traders to estimate the amount of time before which they can sell at a profit for supporting the peg.
This has been suggested in Reweight Without Reweights (using cumulative deviation)
An issue with this approach is that reweights can be sandwiched by arbitrageurs up to the minimum distance from the peg required for a reweight (currently 1%).
However, if the sandwich provides a guaranteed profit, then traders are incentivized to buy the price up to the minimum distance from the peg before the reweight occurs. They will then take profits on the arbitrage in the spread between the peg and minimum distance. This should bring the price close to $.99 closing the gap towards $1.
The primary question is what time interval is best for the reweight cadence. Something on the order of 2-8 hours feels appropriate. Having a predictable and frequent reweight will help bring confidence to traders in supporting the FEI peg.
Capping the burn incentive to a smaller value (1-3%) treats it more like a trading fee and less like a spread that widens to unpredictable sizes further and further from the peg.
This makes it easier for trades to occur, for traders, oracles, aggregators to estimate and model for the worst case outcome even under extreme conditions.
Larger values provide additional deflation to FEI indirectly helping support the peg and collateralization ratio, while smaller values reduce trading inefficiencies and integration issues.
We should add a cap even if it is much higher like 5-10%. The number chosen would also be informed by the decision to remove the mint reward discussed below, which would better suit a value between 1-2%.
The mint reward’s primary function is to close the gap between the burn penalty and the spot price. If the gap is capped to a small enough value, then the mint reward’s utility is diminished.
Removing it would also remove potential economic attack vectors and inefficiencies. An example is minting inflation caused by the price of ETH going down. The price of FEI would be diminished without the necessary burn to ensure deflation. Therefore the mint reward caused net inflation in the FEI price.
Code for fixed cadence reweights can be reintroduced separately from the changes to direct incentives over the coming days. Here is a pull request containing this code: Fixed Reweight Cadence by Joeysantoro · Pull Request #96 · fei-protocol/fei-protocol-core · GitHub
The direct incentives changes can be included in a subsequent proposal which also fixes the vulnerability disclosed through Immunefi.