Liquidity Measures - Idea for New Vault Type

I had an idea about how to create some counter-cyclical liquidity in the system although it will require adding new tools. This is not something I think we can do immediately, but might be a helpful longer term solution.

What if we created a new vault type (I dub it the ‘SETH Vault’) that allowed people to short ETH borrowed only from other MKR vault owners who elected to do so. This would in effect create an internal MKR borrow pool on existing collateral. The SETH vaults would be collateralized by DAI only.

Details below.

Here’s an example.
Regular ETH Vault ‘A’ owns $1mm of ETH. Vault ‘A’ elects to have its $1mm of ETH collateral in the borrow pool to earn rate X (set by MKR) paid in DAI from SETH vaults that borrow. SETH Vault B deposits $100k of DAI and borrows $200k worth of ETH (Z amount of ETH) from the borrow pool at rate X + ‘borrow stability fee’ (set by MKR – MKR keeps the stability fee) paid to borrow pool. SETH Vault B is only allowed to sell the ETH for DAI (through OASIS) and the DAI proceeds can only go to the SETH vault. Now SETH Vault B has $300k of DAI and owes Z ETH ($200k at the time of borrow) to the MKR borrow pool. MKR would set the LR for SETH vaults. Let’s say it’s 150%. Seth Vault B in this example would be right at the liquidation rate. It would have DAI of 300,000 and debt to the pool of Z ETH valued at $200,000 right after the transaction. Any move up in ETH would cause the SETH vault to liquidate. SETH Vaults could always remove any DAI in excess of the LR the same way a regular vault could.

As ETH rises and SETH vaults get liquidated by buying the Z ETH back (keepers would bid Z ETH and get DAI), that ETH is then returned to the MKR borrow pool and the SETH vault holder get any residual DAI left over less a liquidation fee (which goes to MKR). If there is a shortfall in the keeper auction the MKR system immediately prints DAI and buys the ETH it needs to restore the collateral to the pool and hedge market risk. A flop auction is then generated to restore balance on the excess DAI. Remember this liquidation is happening where ETH is in a dramatically rising market so ETH liquidity should be good in a rising market to cover any missing ETH, its the crash scenario where ETH liquidity generally dries up. This would a major risks.

As ETH falls you also now have a built in liquidity source since the SETH vaults will be massively overcollateralized with DAI in an ETH crash scenario. The SETH vaults will have an incentive to sell the extra DAI (or even close out their positions) in their SETH vaults on the market when demand for DAI is needed by regular ETH vault holders who want to sell. It creates a real-time balancing.

The only issue is how to manage liquidations of regular ETH vaults that elected to have their assets in the borrow pool and need to deliver that ETH to the keeper who wins the auction. I would propose to create a buffer between total amount in the borrow pool and total amount allowed to be borrowed from the pool (set by MKR and analyzed based on liquidation values of vaults who elected to be in the pool). For example we would say only 65% of borrowed pool ETH could be loaned out. If for some reason we breach that threshold because 35% of the ETH in borrow pool was liquidated then SETH vaults would be proportionally forced liquidated buy being forced to buy ETH in by auto-selling DAI in their SETH vault to maintain the proper amount of collateral in the system posing no risk to MKR holders except possibly annoyed SETH vault holders. That auto-buy process is basically the same system reg financial brokerages use when lenders need to sell their shares and shorts get force bought in.

The other good thing is DAI held in SETH vaults is not held in DSR and therefore MKR earns full stability fee on that DAI. Maybe that goes away at some point and all DAI can be in DSR even if in a vault.

Let me know your thoughts. We could create contra S’Vaults for each collateral type on MKR or at least ones that fit certain risk profiles. I think it would add stability to the system, help address the liquidity issues in ETH crash scenarios, provide some ability for vault holders to earn a safe amount return on their collateral. It would onboard those who want to short ETH creating a new source of DAI demand. It would earn fees for MKR by taking a piece of facilitating this.

I wanted to throw this out there and see what you all thought? This would have a massive effect on lowering correlation throughout the MKR ecosystem.