The system surplus buffer is the retained earnings of the protocol. It also shows how much MOR would be missing if everyone were to repay their outstanding debt and redeem any remaining MOR for BUSD through the PSM.
It has the following use cases:
Cover potential losses
Fund operating expenses and expansions.
Hedge the treasury with non-MOR yielding assets.
Buyback and Burn GRO
Fund staking rewards
There are two main situations in which losses can appear:
A. Undercollateralized vaults in black swan events
Vaults can become undercollateralized if the price falls below the 100% collateralization ratio mark before the liquidation auction system goes through successfully. The odds of this happening are proportional to the liquidation ratio of the ilk and the volatility/expected max drawdown.
In order to reduce the risk of these events happening, it is important to have safe and high liquidation ratios for each ilk, which limits the max leverage allowed.
Each time a vault is liquidated successfully there is a liquidation penalty applied which builds the system surplus. This penalty is applied to cover potential losses in the aforementioned events. For example:
If the liquidation penalty applied is 15%, then that would be more than enough to cover the losses as long as for every $1 in losses there have been more than $6.67 worth of successful liquidations.
B. Smart Contract Risk:
Each ilk has smart contract risk, whether it is from the token contract itself or the mechanism through which it accrues yield. The way that MOR makes up for this risk is by charging higher stability fees than if it were not to support yielding ilks.
If MOR supports the BUSD/USDC PancakeSwap LP Token without compounding the CAKE rewards, it would only be able to charge a 1% stability fee, whereas by adding the compounding rewards onto the yielding ilk it is able to charge a 5% stability fee.
This 4% yield spread works as the premium for insurance on the smart contract risk, the expected outcome is that this spread more than makes up for the risk being taken.
To minimize smart contract risk as much as possible, the stkToken contracts (i.e. Wheat Vaults) have been audited by ConsenSys Diligence, whose audit report you can read here.
The end goal of Growth DeFi is to be a fully self-governed DAO managed by GRO token holders. As such, GRO holders can allocate the system surplus where they see fit to best spend it to boost the ecosystem’s growth and development.
As part of the DAO’s job in regards to DAO treasury management, they can diversify part of the system surplus (denominated in MOR) into other assets that may produce some yield and hedge having too much concentration on a single token.
When there is more MOR in the system surplus than its buffer target, the protocol will auction MOR which users can then bid on with GRO. The winning bid receives the MOR and burns their GRO. This process works in the same way as Flap Auctions on Maker.
The DAO can fund staking rewards through stkGRO, GRO Yield, or other mechanisms if desired.
This is a side benefit of having a large system surplus.
The formula for calculating system surplus is:
Outstanding MOR Debt + BUSD in the PSM − MOR in Circulation = System Surplus
What this means is that the larger the system surplus is relative to the MOR in circulation, the bigger the artificial demand push will be. In other words, there is simply too much MOR that needs to be bought to repay debts and too little in circulation. Since MOR has a Peg-Stability Module, the price of MOR during these supply shocks is capped at 1.001 BUSD, and anyone can mint MOR at this price through the PSM and arbitrage the difference.
The result of this is an increase in the BUSD held in the PSM contract. In order to reduce this, the debt ceiling for stablecoin vaults can be raised. These vaults offer a decent yield spread with a very high max leverage which can get swallowed up quickly.
It is important to have sizable BUSD reserves before raising the debt ceiling on these stablecoin vaults. If not, the sell pressure caused by users minting MOR and selling it for BUSD and USDC could deplete the PSM resources.
Note that all of the extra MOR minted by stablecoin vault users has to be repaid at some point either from the market, or minted through the PSM (future supply shock), and is accruing a stability fee that increases the system surplus. Then users can just rinse and repeat based on artificial demand.