Understanding the risks and mechanisms of the system
FEI is a highly scalable, decentralized, and reserve-backed stablecoin that can meet DeFi’s needs without relying on centralized assets for collateral. We are humbled by the community that has formed around Fei Protocol. With the upcoming launch of Fei Protocol Genesis on March 31, we want to ensure that our growing community is familiar with exactly how the protocol works, and associated risks.
Fei Protocol uses direct incentives to penalize trades away from the peg and reward trades towards the peg. The net effect is deflation, which helps modulate the FEI supply.
Dynamic fees on FEI selling through direct incentives is a new pattern in DeFi. For example, Uniswap’s interface might show a price of $0.98 for selling FEI, but with the 4% burn for being below the peg, it effectively becomes a price of $0.94. (Read more: Uniswap Incentive Sell/Burn). The user cannot view the burn amount via the Uniswap interface. However, upon trade execution the burn is treated the same as slippage. The slippage parameter Uniswap sets indirectly protects against unexpected large burns. This means the user would never receive less than the amount they opt for, even with direct incentives. Note also that supplying liquidity incurs a burn as if the FEI transferred was sold. Once the protocol is live, people can go to the Fei Protocol app’s trading interface to determine any burn or mint that might apply on their trade.
We strongly recommend people use the Fei Protocol app to trade between ETH and FEI to see the incentive amounts
The burn can be severe, with up to 100% of the trade size at a 10% distance from the peg. This means if you need to sell FEI in a quick time frame during a period of high sell pressure, you could incur a significant burn penalty. FEI’s stability mechanisms are geared towards long-term holding.
Direct incentives only apply to incentivized exchanges. FEI will utilize the Uniswap incentivized ETH-FEI pair starting at the conclusion of Genesis. All other exchanges and transfers should exhibit normal behavior.
At launch, Fei Protocol will use only ETH as the reserve currency. This design decision is core to Fei Protocol’s commitment to decentralization. However, the volatility of the ETH price could potentially lead to an undesirable collateralization ratio.
The white paper discusses the conditions under which the collateral ratio continues to improve or decrease in response to selling pressure. In short, if demand falls faster than the burns captured by direct incentives, Fei Protocol will decrease collateralization over that period. Reweights will step in to restore the price by using Protocol Controlled Value (PCV) to buy and burn FEI. In a serious crisis, the Fei DAO could need to step in and restore a healthy collateralization ratio by minting TRIBE tokens to burn FEI and recapitalize.
If ETH suffers a significant and rapid drop in value, the system could struggle to function properly
Along the way, the Fei DAO can take steps to diversify PCV by implementing bonding curves in stable decentralized assets like DAI and RAI. Fei Protocol can generate an additional collateralization buffer by investing in yield generating opportunities through Yearn and lending markets.
OpenZeppelin has completed a 15 person week audit of Fei Protocol (OpenZeppelin Audit Report). Additionally, ConsenSys Diligence performed a secondary audit of the critical components (ConsenSys Diligence Audit Report).