Messari Q2 Fei Protocol Report: Successfully Coping with the Depegging Test, Initial Operation of the New Governance Mechanism

Written by: John TotalValue Locke, Messari

Compiled by: Frank, ForesightNews

Key Points:

• As the collateralization ratio drops from 2.41 to 1.54, Fei's top priority is to keep the Protocol Controlled Value (PCV) above the circulating FEI held by users to support FEI's peg to the dollar;
• The supply of FEI has decreased by over 36% in Q2;
• The new governance structure is functioning as expected, but some decisions require a stronger consensus from the DAO;
• Rari's development faces resistance, with its main product Fuse being hacked, resulting in a loss of $80 million, and Rari's co-founders have also left;
• The current market conditions necessitate delaying product launches and focusing first on survival;

Introduction to Fei Protocol

Fei Protocol

Launched in April 2021, Fei Protocol innovatively introduced Protocol Controlled Value (PCV), which supports its algorithmic incentives created to peg stablecoins.

Since PCV is neither debt nor minting tax, there is no risk of liquidation events or death spirals; the risk solely depends on the value and volatility of PCV assets, which are currently used to provide liquidity and earn yields. The "collateralization ratio" specifically refers to the ratio of the circulating supply of FEI to the value of PCV, serving as a key indicator for measuring the peg status.

Fei V2

Fei V2 was launched in October 2021, removing the direct incentive mechanism favoring 1:1 redemptions of FEI for ETH, DAI, and LUSD, and instead supporting a reserve pool for minting/redemption mechanisms managed by the DAO, with a current spread of 0.5%.

As part of V2, the DAO has placed TRIBE (the governance token of the project) on equal footing with FEI, which serves as a minting tax------TRIBE can now benefit from the profits of PCV in a buyback form, and it will also play a supportive role if PCV cannot support the existing stablecoin supply.

Additionally, in January 2022, Fei Protocol merged with Rari Capital to form Tribe DAO.

Overview

In Q2 of this year, several stablecoins faced the challenge of decoupling, and FEI undoubtedly succeeded.

FEI aims to be a stablecoin supported by PCV, with the DAO controlling the PCV and deciding how to allocate it, thus needing to find a balance between riskily developing PCV and maintaining support for the FEI peg.

In reality, the choice of which asset to use as PCV reserves in Q2 is not significant------almost all assets (in dollar terms) are declining. Therefore, the Fei DAO made many decisions in Q2 to consolidate PCV assets and increase stablecoin holdings.

On April 30, Rari Capital's pool on Fuse was attacked, with hackers profiting nearly $80 million; furthermore, the core team of Rari has largely departed, leaving only one member after less than six months of the merger.

However, another significant change this quarter was the implementation of a new governance structure. "Optimistic governance" aims to expedite simple decisions while slowing down difficult ones.

The Tribe DAO committee is elected and has the authority to execute most transactions for the DAO, subject to time locks, meaning each action is subject to veto voting by the newly established NopeDAO, with all TRIBE holders able to vote in support of NopeDAO proposals.

Proposals such as selling ETH to increase support for FEI stablecoins encountered no issues, while decisions like implementing repayments for the Rari hack took longer, with the first attempt being rejected; governance discussions are currently ongoing to find the best approach.

TribeDAO has been working on developing products to increase the adoption of FEI, targeting other DAOs as its customers, but due to the freeze of Fuse (Rari's main product) after the hack and the DAO's continued focus on maintaining FEI support, product launches have been delayed.

Performance Analysis

FEI Stablecoin

From the perspective of average daily prices, FEI remains more volatile in its peg to the dollar compared to the four major stablecoins: DAI, USDC, USDT, and FRAX.

While increasing adoption should help reduce this volatility, part of the reason lies in the design of the Price Stability Module (PSM):

The DAO manages the primary mechanism for maintaining the peg through the PSM------ FEI's PSM allows users to swap FEI for DAI, LUSD, ETH, and RAI, with the price of FEI in these PSM transactions determined by the DAI TWAP oracle, using a $1 oracle service in cases of DAI depegging.

The DAO controls the funds of each PSM, with no mandatory mechanism for maintaining the peg when empty, but during turbulent times, arbitrageurs typically have more opportunities to trade with the PSM and help maintain the peg, and the DAO must ensure that this mechanism operates smoothly.

Additionally, the DAO generates fees for minting and redeeming FEI while pegged, adjusting these fees to incentivize or suppress the use of the PSM.

Currently, most FEI is in TribeDAO lockers, and the team has removed the FEI owned by the protocol from lending markets and DEXs; furthermore, since FEI is not widely used as collateral, it is currently utilized on DEXs.

Protocol Controlled Value (PCV)

Adverse market conditions, recent exploit-induced liabilities, and increased FEI redemptions have all put pressure on the protocol's PCV. Therefore, the DAO voted at the end of this quarter to simplify its PCV allocation, increasing FEI's dependence on stablecoin support.

We adjusted the reserve ratio (RR) to include the FEI owned by the protocol in both assets and liabilities, thus RR = (PCV + FEI owned by the protocol) / Total supply of FEI.

This measure more accurately represents the DAO's current risk and capacity for minting new FEI against PCV, any minting of FEI will push this ratio towards 1, indicating increased risk. However, this measure has two limitations:

1. Once the ratio exceeds 1, it becomes useless, as minting new FEI will push it back to 1;
2. It does not account for FEI that remains idle in the TribeDAO wallet after minting;

Therefore, the previously used collateralization ratio (CR) will be retained, i.e., CR = PCV / FEI used by users in circulation, which we believe accurately represents the DAO's total borrowing capacity.

To execute repayments, the Tribal committee must allocate existing PCV assets or sell assets to buy back the stolen assets, with an estimated price of about $40 million as of June 30, 2022, of which only about $4 million is ETH, the rest being stablecoins, detailed as follows:

Source: @Eswak (TribeDAO community member and contributor)

Assuming full repayment to the hack victims at current prices (as of June 30, 2022), we updated the collateralization ratio (CR) and stable support ratio (SB), and we also ran PCV scenario analyses based on different ETH prices.

The core team recommends using the stable support (SB) ratio, which helps inform the market risk of the current PCV relative to the FEI used by users in circulation------with the recent PCV consolidation, the SB ratio is 91%, meaning that even if ETH drops below $200, it can still cover its stablecoin liabilities.

If the DAO fully compensates for the losses from the hack, this situation would change dramatically------assuming full repayment and no changes in PCV allocation, the SB ratio would drop to 63%, meaning that ETH below $700 could put FEI at risk.

TRIBE

TRIBE fell by 72% in Q2, while Ethereum dropped by 66%; the token currently has a market cap of $124.8 million (as of June 30, 2022, assuming a circulating supply of 832 million TRIBE).

The equity value of the protocol can be measured by subtracting the FEI used by users in circulation (liabilities) from the PCV (assets).

We estimate that approximately 832 million TRIBE are in circulation, with an additional 148 million TRIBE allocated to Fei Labs, investors, and individual contributors over the next three years.

Using 832 million as the circulating supply, we calculate the TRIBE net value multiple by dividing the circulating market cap by the protocol equity:

$125 million / [ $204 million - $132 million ] = 1.74x

This metric helps us understand the external value or market growth expectations of TRIBE------if the protocol were to liquidate today, TRIBE holders would recover about 57% of their current positions, leaving the remaining 43% based on expectations of future returns.

Qualitative Analysis

Drivers of FEI Demand

Fei Protocol focuses on growing into a DAO-to-DAO (D2D) liquidity solution. Turbo was launched on April 20 but failed to launch due to the Fuse hack and asset freeze.

Turbo can help DAOs effectively utilize treasury assets while increasing the liquidity of the protocol's native token, with the core measure being TribeDAO's zero-interest stablecoin loans:

In this setup, borrowers provide collateral (usually local treasury assets, broadly referred to as TKN) and receive an equivalent amount of FEI, which must be allocated to the loan pool and matched with an equal amount of TKN, while the borrowing DAO and FEI will share the fees and interest from that loan pool.

This way, borrowing DAOs can effectively leverage their treasury assets while providing liquidity to holders in the form of a stablecoin loan pool, and in return, TribeDAO can also earn yields.

Will Turbo become a driver of demand for FEI? Certainly, as TKN holders will add TKN as collateral and withdraw FEI, and vice versa. For example, the first Turbo partnership program is with Balancer; given the veBAL rewards, purchasing FEI, depositing collateral, and withdrawing BAL may be economically attractive. Users can then participate in veBAL token economics and earn income in this way.

Although this transaction certainly involves more variations and risks than discussed here, this setup is expected to reasonably drive demand for FEI.

Optimizing PCV Yields

In a scenario similar to the growth of FEI demand, the DAO needs to create opportunities for generating new yields from FEI's PCV.

Historically, the DAO's primary use of PCV has been to borrow money to mint FEI and deposit it into the Fuse pool, with similar strategies adopted on DEXs for FEI/wETH or other trading pairs, but the DAO is also open to new use cases for diversifying PCV and generating returns.

For instance, before the PCV consolidation at the end of this quarter, the DAO utilized its partnerships with other protocols to generate yields, with two examples:

• The DAO holds LUSD as a PCV asset and needs to fund its PSM. Therefore, the DAO can also participate in Liquity's liquidation pool for additional yields (Liquity is a lending platform similar to MakerDAO but requires a lower initial collateralization ratio and has faster liquidation speeds);
• As part of the collaboration with Balancer, TribeDAO earned 200,000 BAL in a liquidity swap and paired it with ETH, allowing TribeDAO to participate in veBAL rewards, leveraging its voting power, enabling the DAO to create a 30% annual yield for the FEI/wETH liquidity pool on Balancer, which increases LP yields and may consequently boost demand for FEI;

Governance

Last quarter, TribeDAO voted to change its governance structure to Liquid Representative Democracy, electing nine council members to manage the Optimistic time-lock multisig (5-of-9 multisig).

The Tribe committee can implement almost any change through time locks------granting TRIBE holders oversight of the Tribe council through on-chain governance voting by NopeDAO.

Fei-Frax Alliance

On May 18, Joey initiated the Frax x Fei Stablecoin Alliance‎, with FEI replacing UST in Curve's 4pool and creating a new FEI-FRAX-DAI 3pool on Balancer.

Frax is one of the largest veCRV holders and will direct rewards to the 4pool, while Fei will direct veBAL rewards to the 3pool, which could be very beneficial for Fei's PCV protection and the outlook for stablecoin demand.

Conclusion

For Fei Protocol and TribeDAO, Q2 of this year has been a challenging quarter.

With FEI backed by stable PCV, the new governance structure may have saved the DAO as it retains PCV and refocuses the community to seek new solutions, but this structure also poses risks for future governance processes------potentially leading to a freeze in product development and protocol growth.

Currently, for FEI, survival is paramount.