II. RISK FRAMEWORK

A. Credit Enhancement

Two types of credit enhancement are used which enables prudent lending:

Overcollateralization (margin or haircut) refers to holding an amount of collateral that exceeds the value of the loan and can provide a buffer against fluctuating collateral prices.

Insurance is used to protect collateral value against catastrophic price events. Stablecoin borrowers insure their collateral by paying premium protection payments over time on a Token Event Swap (TES) an innovative smart contract which triggers bail-out if a price event occurs in exchange for premium payments. Insurers take on risk to earn the premium and provide loan backing by escrowing crypto tokens into an insurance asset pool.



B. Solvency

The stablecoin will have stable value to the extent that loans either have excess collateral or that the insurance is sufficiently capitalized. Therefore our smart contract models the capitalization of the insurance with critical importance. The system applies the Solvency II risk framework used by insurance regulators in the EU.

Solvency Ratio measures insurers ability to bail-out undercollateralized loans, see Figure 1. Own Funds is the amount of crypto collateral insurers have escrowed (assets) above the market value of TES insurance that borrowers have purchased (liabilities). Solvency Capital Requirement (SCR). A natural question is how much ”Own Funds” is sufficient? SCR is defined as this required amount, for a given tolerance of certainty. Solvency Ratio > 100% is an example of a desirable limit set by VIG custodians.



SCR is obtained as shown in Figure 2 as the change in Own Funds between normal and stressed markets. To arrive at SCR the core operation is to conduct a stress test per Solvency II which provides information about the required quantity of crypto collateral that should be escrowed by insurers to maintain solvency. For this stress test the project implements a TES pricing model to provide a best estimate for market value of the TES liabilities in normal conditions and a stress model for what their shocked value might be (given varying levels of certainty). Own Funds equals the amount of crypto collateral pledged by insurers minus our best estimate normal market value of the TES contracts. Stressed Own Funds equals the stressed value of crypto collateral pledged by insurers minus our best estimate stressed value of the TES contracts. Finally, SCR is the change in Own funds due to stressed markets and Solvency Ratio is the ratio of Own Funds to

C. Stress Model

The stress model is a copula based Monte Carlo simulation of correlated extreme price events. The simulation generates the portfolio loss distribution as in Figure 3. Results of the stress model has three categories of loss, expected loss which is backed by overcollateralization, unexpected loss which is backed by insurers, and stress loss which is backed by VIG final reserves (see subsection II-F). Three key inputs to this model are probability of each collateral token having an extreme price event, their correlation, and the amount lost (1- recovery) due to an event. Probability (derived from hazard rate) and recovery are obtained from TES market prices, see subsection III-B Price Discovery. Correlations will be modeled from token returns through common latent factors and a stressed scenario of the correlation structure will be used. This stress model is used primarily to simulate unexpected loss to obtain SCR and Solvency Ratio but will also provide a measure of capital efficiency and risk concentration (Risk Adjusted Return on Capital and contribution to RAROC) to indicate system health.

D. Structured Product

All TES loan insurance contracts written to insure collateral are taken together as a basket of TES to form an aggregated insurance premium. Insurers take the other side by selling protection on notional amounts of a basket TES (a single TES written on a basket of collateral), see Figure 4. The basket TES may be tranched in later releases.

E. Bail Outs

A TES is triggered for bail-out if collateral value falls below the value of debt for a given loan. If a TES is triggered then the basket TES protection sellers would immediately take-over (take ownership of) and recap the undercollateralized loan realizing a loss. Gains and losses of the insurance asset pool is shared accross sellers. Participation is commensurate with contribution to solvency defined as the change in Solvency Ratio resulting from a given TES seller escrowing tokens into the insurance pool. Handling bail-outs does not require auctioning collateral into distressed markets; the basket TES is both funded and physically settled.

F. Final Reserve

Premiums paid-in by borrowers is required to be denominated in VIG tokens and must be posted prior to drawing loans; insufficient maintenance of VIG balance triggers bailout of the loan with borrower retaining any excess collateral. Insurers are paid denominated in VIG. The system stores a cut of VIG premiums as final reserves after making VIG payment to insurers. VIG final reserves is used recap the system if at any time the insurance asset pool is depleted, covering the so-called stress losses as depicted in Figure 3.

Vigor Stablecoin and DAC Social Links

telegram : https://t.me/vigorstablecoin

member client : https://vigor.ai

website : http://www.vigorstablecoin.com

github : https://github.com/vigorstablecoin

whitepaper : https://vig.ai/vigor.pdf

twitter: https://twitter.com/vigorstablecoin

Up Next: The White Paper Chronicles Vol. 3: Pricing Framework