# Further Smart Yield Brainstorming
This note is in response to Fully's proposal for [Smart Yield v3](https://https://hackmd.io/@fully/H1Q7Bui0i).
## Preamble
Fully introduced the concept of *Unstoppable Vaults* in their note. An unstoppable vault behaves as follows:

* Deployed with a target yield originator specified
* Allows users to lock deposits in exchange for a share in a known amount of yield
* Charges a fee on redemptions to accumulate vault-owned liquidity
* Grow vault-owned liquidity over time so as to finance deposits

Given that vault-owned liquidity would require years to reach a meaningful threshold vis a vis the yield it is able to sustainably offer to attract deposits, the note further illustrates how deposits could be attracted in the short term through either a sponsor's subsidization or the renting of Barnbridge treasury liquidity.

**The purpose of this note is to rethink the proposal within the context of FIAT II.** This was spurred by two main responses to Fully's note.

1. **The Scale of the Barnbridge Treasury:** When segregated runway is taken into account, the Barnbridge treasury offers less than a million in liquid capital to help subsidize Unstoppable Vault yield generation. This means that any market demand for Unstoppable Vaults could be satisfied by a forking of the proposed concept with a project that has a larger treasury. See "[Olympus Treasury Bonds](https://forum.olympusdao.finance/d/1001-oip-72-fiat-dao-x-olympus-partnership)" section in the linked forum post for an example.
2. **The Existence of FIAT II:** Barnbridge is a stablecoin protocol going forward, which means it has the ability to leverage credit generation for the products in its ecosystem. Rethinking Smart Yield v3 in this context could allow us to punch above our weight, while making FIAT II all the more robust.

## Smart Yield v3 as a Captive Insurer
DeFi, like any other financial market, has demonstrated that participants operate on a graph of risk and reward when deciding where to provide liquidity. As we consider the impending launch of FIAT II, it becomes imperative that users can earn yield on FIAT holdings commensurate with the perceived risk of such positions. There are two ways that development efforts can ensure the feasibility of equilibrium yields as supply expands:

- **Increase Reward**
- **Decrease Risk**

Stablecoin issuers to date have focused explicitly on increased rewards. As quantifying risk in DeFi is far more convoluted than the annualized reward of a liquidity pool or a lending market, this is to be expected. However, this path of least resistance is crowded as a result, with the cost of liquidity essentially being at the mercy of a growing group of not only stablecoins but also liquid-staking derivatives. FIAT II will need to play this game as well, but it can differentiate itself by reducing the expected yield required by its holders.

### Defining FIAT II Risk
The risk of holding FIAT either in a wallet or via pooled exposure lies in the accrual of *bad debt*. Bad debt is defined as FIAT that is not properly collateralized by protocol deposits. While FIAT II is fundamentally a CDP-style stablecoin, meaning that LUNA / UST-style deathloops are not an outright possibility, collateral failures can play out. The outcome of such collateral failures tends to be a repegging of the stablecoin at a lower equilibrium circulating supply, but given the expectation of FIAT II supporting a very long tail of assets, as well as semi-secured borrowers, it is likely that market participants will treat it with caution for quite some time.

With that in mind, it can be argued that the equilibrium yield demanded by those with FIAT exposure will be lower if the perceived risk of bad debt accrual is mitigated. Existing solutions to bad debt accrual (outside of pledging credit or public auctions) include governance token emissions, staked governor slashing, and the issuance of recovery bonds -- all of which leave more robustness to be desired.

### Insuring FIAT II
And this is where Smart Yield v3 can come in: **as an insurance module for FIAT II.** Why is the concept well-suited to this task?

- **Known Duration:** Each Smart Yield depositor agrees to a fixed term
- **Diverse Asset Base:** Smart Yield vaults can be deployed for any yield originator
- **Quantifiable Liquidity:** All vaults would be based onchain

Conversely, Smart Yield as it has been implemented to date, as well in the proposed V3, would represent a cost center to the DAO. It is predicted that external partners would seek to acquire governance over the direction of subsidies, but such arrangements typically involve a non-linear payoff for such strategies (i.e., giving away $1 of realized yield for less than $1). This calculus can be improved if the theoretical dollar of yield represents a below-market insurance premium paid.

The promise of below-market insurance premia lies in the TardFi analogue of [captive insurance](https://www.captive.com/captives-101/what-is-captive-insurance).

## Proposed Modifications
This shift in the purpose of Smart Yield v3 does not require a significant departure from the design proposed by Fully.
- **Vaults would still be deployed for specific originators**
- **Vault-controlled value would still accrue over time**
- **Vaults would still have corresponding gauges**

The differences would instead stem from **a)** the source of augmented yields, and **b)** the obligations of depositors. Also up for discussion would be the removal of principal tokens and set epochs.

### Protocol Emissions
For the purposes of this note, it is assumed that the Barnbridge treasury will not be in a position to contribute any assets as either collateral or yield. What it can offer, however, are proceeds from FIAT II interest generation.
1. **FIAT II retains some amount of minting interest for SY v3**
2. **Interest is distributed to SY vaults via gauges**
3. **Depositors receive interest per block proportionate to their time-weighted deposit**

It is expected that partner projects would look to launch vaults and acquire governance support for their respective liquidity pools, as this product subsidizes liquidity and locks it.

### Insurance Mechanism
Depositors will be obligated to serve as an insurance module for FIAT II. In practice, this means assuming any bad debt that accrues to the protocol, with certain caveats.

**Disproportionate Distribution**
Bad debt would be distributed across all Smart Yield vaults in accordance with their time-weighted value. Longer-term depositors will thus take on less than the average amount of bad debt distributed per dollar of deposits. Depending on how the VaultRegistry is implemented, we would also want to discuss concerns around adverse selection to ensure that bad debt isn't distributed to volatile vaults, which themselves could render the "insurance" moot.

**Cap on Redistribution**
To ensure that depositors can understand their max loss, a cap would be placed on the negative yield a position could take. Whether this would be a universal cap or a parameter determined at deposit is up for discussion. If this / these cap(s) preclude all bad debt from being repaid, then the bad debt would fall back to other recovery modules. And to ensure that remaining bad debt does not act as an overhang discouraging future deposits, only bad debt that accrues after a position is taken can be attributed to it.

**Encouraging Rollovers**
If the realization of the negative yield represented by bad debt is executed upon deposit withdrawal, it may be in the interest of the protocol to allow depositors to roll over without triggering the loss. This allows the depositor to speculate on the future value of their deposit and expected Smart Yield distributions, potentially mitigating the magnitude of the loss. From the protocol perspective, the bad debt would remain collateralized by the Smart Yield deposit.

## Implications and Open Questions
The goal of this proposal is to knock out two birds with one stone: sustainable yield generation for Smart Yield and a lower cost of liquidity for FIAT. If successful, it would see countless partners compete over yield distribution for locked deposits into their liquidity pools, while providing FIAT II with a cheap and diversified insurance module. Thinking even further, if such partners themselves have FIAT credit lines, they could participate in the system with FIAT-denominated LPs, entrenching use.

The following are remaining considerations that would impact implementation.

### Term Structure
The original note proposed a principal token and epoch implementation for vault deposits. This model has proven itself undesirable with other yield-splitting protocols and some, like Element, are moving to fixed duration deposits set by users. For Smart Yield v3 to implement a similar UX would require us to consider how distributed yield is competed for at the vault level. I think it's a worthwhile consideration because having manually set epochs is poor UX and would scale poorly as more vaults get onboarded.

### Redemption Participation
FIAT II allows for depositors to set a price at which they would be willing to have their collateral redeemed for FIAT. If we extend this functionality to Smart Yield, it would increase the overall liquidity of the redemption mechanism and allow Smart Yield depositors to earn even more yield (depending on the face value they accept FIAT at).

### Credit Rights
One way to encourage further deposits into Smart Yield would be access to FIAT minting rights. As we know when their redemption time would be, it allows for more granular risk management. Moreover, this would reduce volatility in the overall FIAT deposit base as there would not be a risk of early withdrawal. Items to consider would be how to ensure that this doesn't compromise a deposit's ability to act as insurance capital, and how vaults would get extended the privilege.