CS Note 8.5: Fully Backed Branches Can Have Low Interest Rates

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Redemptions are distributed between branches according to their "unbackedness". If a branch has more BOLD in the stability pool than it has outstanding debt, it is considered "fully backed" and no redemptions are routed to it.

Usually, users are encouraged to pay a high interest rate to avoid redemption. However, in the case of a fully backed branch, no redemptions can happen in that branch, so there is no longer an incentive to pay more than the minimum interest rate. As a result, it should be expected that the interest rate on fully backed branches will be the minimum interest rate.

The troves at the minimum interest rate risk that the branch will become unbacked, as this will re-enable redemptions. This can happen through withdrawals from the stability pool, liquidations, or through more debt creation on the branch. However, if this happens gradually, there will still only be a small percentage of redemptions executed through that branch (affecting the latest troves to adopt the strategy), as its unbackedness will still be quite low. As soon as the branch becomes unbacked, the trove owners can react by increasing the interest rate again (or depositing more BOLD to the stability pool). If the owners need to adjust, they may need to pay an upfrontfee for doing so.

This problem could be self-correcting if stability pool depositors withdraw when the average interest rate of the branch drops, as this will result in a lower yield paid to the stability pool. It is unclear how this would play out in practice.