Incentivize Interlay iBTC capacity as Polkadot common good

Tl;dr: The Interlay community seeks Polkadot Treasury support for more iBTC collateralization since iBTC is used throughout the Polkadot ecosystem as a common good. We propose that the Polkadot Treasury support incentivizing 45 iBTC with a grant of 202,030 DOT.

Background
Interlay continues to operate as the main BTC bridge & Bitcoin DeFi Hub of the Polkadot ecosystem. The Interlay Bridge & DeFi Hub has stood the test of time & continues to be the most secure bridge for Bitcoin DeFi. The bridge has handled 711 BTC in bridge volume and currently provides 53.6 BTC to the Polkadot ecosystem and was recently as high as 89.5 iBTC. Due to high iBTC demand by hodlers, DEXs, and money markets there is again no spare capacity to mint more iBTC.

Interlay Actions to Increase iBTC Capacity

The number 1 priority for Interlay will always be to ensure the secure operation of the BTC bridge & DeFi Hub. INTR emissions incentivize vault operators to collateralize or back the minting of iBTC. But the primary beneficiaries of tokenized BTC have been DEXs and there wasn’t enough iBTC mint/redeem volume to significantly contribute to vault incentivization. Therefore the Interlay team reduced iBTC mint/redeem fees to near zero over a year ago, basically operating iBTC as a common good for the Polkadot ecosystem.

The Interlay community plan to work on the following important features to continue Interlay’s growth and make iBTC sustainable:

• Add new lending markets, continuing to grow Polkadot’s lending market.
• Add new vault collaterals to increase diversity and allow for more BTC to flow into Polkadot’s ecosystem.
• Research how to further improve the Vault model for the Interlay bridge via collateral delegation and shared multisig Vaults.

We also support calls to reduce Polkadot inflation and staking rewards, as long as the real yield is maintained. Reducing the DOT staking APR would reduce the high yield (and INTR emissions) required to compensate DOT vault operators for lost staking rewards. (Luckily Bifrost and Interlay have teamed up to enable VDOT as iBTC vault collateral, reducing the need to compete against DOT rewards when using VDOT as collateral.)

Treasury Proposal

Last but not least, we believe that the DOT treasury can play a role in increasing the collateral capacity to mint more iBTC as part of the broader Polkadot DeFi liquidity campaign. After discussing options with the community in https://polkadot.subsquare.io/posts/263 we are proposing executing Option 1, that the Polkadot Treasury grants DOT to Interlay to pay out as vault rewards.

The original goal of Polkadot referendum 432 was for the Polkadot Treasury to grant enough DOT to cover the current vault rewards for a year for all of the iBTC that is currently in use outside of the Interlay chain. Based on sibling acct balances, there are 27.357 iBTC on parachains other than Interlay (with 25.1 iBTC on HydraDX). This 27.357 iBTC in the Polkadot ecosystem is currently worth $1.76M. Additionally, both HydraDX and Stellaswap will soon begin their partially-treasury-funded liquidity campaigns (ref 561 and ref 580), including increasing iBTC liquidity on their platforms. HydraDX has a goal of increasing iBTC-WBTC liquidity to $5.5M, up from $2.85M currently¹. Stellaswap’s goal is to increase DOT-iBTC to $1M, up from $35.9k currently². Together these will drive market demand for an additional 28.1 iBTC ($1.8M), but only if there is Interlay vault capacity to mint the additional iBTC against. Instead of asking the Polkadot Treasury to cover vault rewards for both the existing 27.357 and the incoming 28.1 iBTC demand (55 iBTC in total), we propose for the Polkadot Treasury to incentivize 45 iBTC capacity for use throughout the Polkadot ecosystem as part of the overall ecosystem liquidity campaign. Note that none of the Polkadot Treasury funds would directly benefit the Interlay team.

What will it cost to incentivize vault capacity for 45 more iBTC? The most popular vault collaterals are VDOT ($4.2M locked) and DOT ($2.0M locked). The initial secure collateralization threshold for VDOT vaults is 135% when opening a vault, 115% for premium redeem, and liquidation at 105%. At 135% collateralization, a VDOT vault currently earns 46.5% APR. Recently a large vault closed, which has boosted this APR, so let’s assume a lower target of 40% APR at 135% collateralization. The current price of BTC is $64,439, so the annual rewards to incentivize 45 iBTC at 40% APR and 135% collateralization is $1.56M.

We request 202,030 DOT ($1.56M at $7.74/DOT 30-day EMA) to incentivize capacity for 45 iBTC for 12 months. The granted DOT would be immediately staked as vDOT so that it appreciates with staking rewards throughout the year, further increasing the total value paid out to vault operators. A slow long-term DCA will be used to sell the vDOT to buy INTR which would be added to the existing INTR rewards paid out to vault operators, increasing overall vault rewards. The immediate impact would be to boost the vault reward rate to 46.5% * (53.6+45)/53.6 = 85.5% APR. Vault operation is technically challenging and therefore ‘sticky’, but that APR boost should be enough of an initial change to draw attention, motivating additional vault operators to lock collateral, creating more iBTC capacity. Likely enough new collateral is locked in vaults so that the overall rewards APR (including both INTR and DOT rewards) will fall back to the current APR.

After the on-chain proposal is passed, we will initiate follow-up Interlay governance referenda to:
1a) send the entire DOT grant to the Interlay sibling account on Bifrost chain.
1b) stake the DOT on Bifrost chain to receive VDOT.
2a) move the staked VDOT on Bifrost to the Interlay sibling account on HydraDX chain.
2b) Initiate a 12-month-long DCA to sell that VDOT for INTR.
3) increase the INTR vault reward rate according to the additional DOT rewards granted by the Polkadot treasury in order to incentivize the additional iBTC capacity.
4) Periodically move purchased INTR on HydraDX back to the Interlay treasury to continue payouts to vault operators.
The increased INTR vault rewards emissions and the purchases of INTR from the Omnipool should overlap and cancel out their effect on the INTR price.

Disclosures: I am not an Interlay team member. However, I am an Interlay vault operator so I will indirectly benefit from increased vault APR until the rewards rate falls back to its current equilibrium rate (40-50%). I created this proposal at the urging of the Interlay community and will be reimbursed from the Interlay treasury for my time creating this proposal.