Tl;dr: The Interlay community seeks Polkadot Treasury support for more iBTC collateralization since iBTC is used throughout the Polkadot ecosystem as a common good. We propose that the Polkadot Treasury support incentivizing 40 iBTC and propose three methods to achieve this objective.

Background
Interlay continues to operate as the main BTC bridge & Bitcoin DeFi Hub of the Polkadot ecosystem. The Interlay Bridge & DeFi Hub has stood the test of time & continues to be the most secure bridge for Bitcoin DeFi. The bridge has handled 711 BTC in bridge volume and currently provides 61.5 BTC to the Polkadot ecosystem and was recently as high as 89.5 iBTC. Due to high iBTC demand by hodlers, DEXs, and money markets there is again no spare capacity to mint more iBTC.

Interlay Actions to Increase iBTC Capacity

The number 1 priority for Interlay will always be to ensure the secure operation of the BTC bridge & DeFi Hub. INTR emissions incentivize vault operators to collateralize or back the minting of iBTC. But the primary beneficiaries of tokenized BTC have been DEXs and there wasn’t enough iBTC mint/redeem volume to significantly contribute to vault incentivization. Therefore the Interlay team reduced iBTC mint/redeem fees to near zero over a year ago, basically operating iBTC as a common good for the Polkadot ecosystem.

The Interlay community plan to work on the following important features to continue Interlay’s growth and make iBTC sustainable:

• Add new lending markets, continuing to grow Polkadot’s lending market.
• Add new vault collaterals to increase diversity and allow for more BTC to flow into Polkadot’s ecosystem.
• Research how to further improve the Vault model for the Interlay bridge via collateral delegation and shared multisig Vaults.

We also support calls to reduce Polkadot inflation and staking rewards, as long as the real yield is maintained. Reducing the DOT staking APR would reduce the high yield (and INTR emissions) required to compensate DOT vault operators for lost staking rewards. (Luckily Bifrost and Interlay have teamed up to enable VDOT as iBTC vault collateral, reducing the need to compete against DOT rewards when using VDOT as collateral.)

Treasury Proposal Options

Last but not least, we believe that the DOT treasury can play a role in increasing the collateral capacity to mint more iBTC as part of the broader Polkadot DeFi liquidity campaign.

The original goal of Polkadot referendum 432 was for the Polkadot Treasury to grant enough DOT to cover the current vault rewards for a year for all of the iBTC that is currently in use outside of the Interlay chain. Based on sibling acct balances, there are 27.357 iBTC on parachains other than Interlay (with 25.1 iBTC on HydraDX). This 27.357 iBTC in the Polkadot ecosystem is currently worth $1.89M. Additionally, both HydraDX and Stellaswap will soon begin their partially-treasury-funded liquidity campaigns (ref 561 and ref 580), including increasing iBTC liquidity on their platforms. HydraDX has a goal of increasing iBTC-WBTC liquidity to $5.5M, up from $3.3M currently¹. Stellaswap’s goal is to increase DOT-iBTC to $1M, up from $35.9k currently². Together these will drive market demand for an additional $1.58M or 22.5 iBTC, but only if there is Interlay vault capacity to mint the additional iBTC against. Instead of asking the Polkadot Treasury to cover vault rewards for both the existing 27.357 and the incoming 22.5 iBTC demand (nearly 50 iBTC in total), we propose for the Polkadot Treasury to incentivize 40 iBTC capacity for use throughout the Polkadot ecosystem as part of the overall ecosystem liquidity campaign. Note that none of the Polkadot Treasury funds would directly benefit the Interlay team, nor would current INTR rewards to vaults be reduced.

What will it cost to incentivize vault capacity for 40 more iBTC? The most popular vault collaterals are VDOT ($5.1M locked) and DOT ($2.5M locked). The initial secure collateralization threshold for VDOT vaults is 135% when opening a vault, 115% for premium redeem, and liquidation at 105%. At 135% collateralization, a VDOT vault currently earns 51.29% APR. Recently a large vault closed, which has boosted this APR, so let’s assume a lower target of 40% APR at 135% collateralization. The current price of BTC is $70,845, so the annual rewards to incentivize 40 iBTC at 40% APR and 135% collateralization is $1.53M.

There are a few ways this could be executed, depending on the community’s preference:

Option 1 - Polkadot Treasury grants DOT to pay out as vault rewards

We would request 177,906 DOT ($1.53M at $8.60/DOT) to incentivize capacity for 40 iBTC utilized within the rest of the Polkadot ecosystem for 12 months. In addition to the INTR rewards paid out to vault operators, treasury DOT would also be paid out, increasing overall vault rewards. The immediate impact would be to boost the vault reward rate to 51.29% * (61.5+40)/61.5 = 84.6% APR. Vault operation is technically challenging and therefore ‘sticky’, but that APR boost should be enough of an initial change to draw attention, motivating additional vault operators to lock collateral, creating more iBTC capacity. Likely enough new collateral is locked in vaults so that the overall rewards APR (including both INTR and DOT rewards) will fall back to the current APR. A variant on Option 1 is to convert the treasury DOT into VDOT and pay out VDOT so that it appreciates with staking rewards throughout the year, increasing the total value paid out to vault operators.

Pro1: The DOT grant can be handled securely by transferring it directly from the DOT treasury to an Interlay system account or team multisig on the Interlay chain for rewards payouts.

Pro2: Polkadot Treasury DOT is not at risk of liquidation

Con1: The DOT grant will be spent and is therefore not perpetual.

Option 2 - Use VDOT staking rewards to perpetually increase vault staking rewards

The Polkadot Treasury could loan DOT which is DCA swapped to VDOT and held on the HydraDX chain. There is a “Yield DCA” feature which will automatically and periodically sell your extra staking rewards for a token of your choice. We could set it up so that some of the VDOT growth in value is automatically sold for DOT, held in the Interlay sibling account on HydraDX. Periodically (every quarter?) Interlay governance could XCM transfer that accumulated DOT staking reward back to the Interlay chain to pay out as vault rewards. Similar to Option 1 the vault APR would initially increase to 84.6% and then fall back down as more vaults and collateral came online.

Assuming a staking rewards rate of 15%, a loan of 1,186,046 DOT ($10.2M at $8.60/DOT) would yield $1.53M of DOT every 12 months which would perpetually incentivize the same 40 iBTC capacity ($1.53M).

Pro1: the DOT is not ‘spent’ and can indefinitely provide iBTC capacity.

Pro2: Funds are held in a decentralized manner with no risk of liquidation.

Con1: This is the most complicated setup and requires the most upfront capital.

Option 3 - Loan DOT collateral to trusted vault operators who would directly create iBTC minting capacity against the treasury’s DOT collateral.

The DOT could be staked as VDOT with Bifrost, VDOT lent in the Interlay money markets, and the resulting qVDOT tokens used to collateralize iBTC vaults. This would multiply the liquidity that the loaned DOT enabled. Since there is a risk of vault liquidation in volatile market conditions, the treasury vaults could be set with a very conservative custom secure collateralization ratio like 300%. A loan of 988,534 DOT ($8.5M) at 300% collateralization would add 40 iBTC capacity in perpetuity.

The Polkadot treasury could earn INTR emission rewards, using this Protocol Owned Liquidity to earn revenue for DOT holders. However, if the Treasury vault earns INTR rewards and sells them for DOT, it'll continue to put downward pressure on INTR, reducing incentive for other vault operators. Therefore the loaned DOT wouldn’t create as much vault capacity, diluting the value of this proposal. Therefore we suggest disabling rewards to DOT Treasury vaults since the primary purpose is to maximize the increase in iBTC capacity.

Since the Interlay vault client requires the ability to liquidate a vault’s collateral or pay 10% out during a premium redeem, the private key must be held on the server in plain text. Unfortunately that means that you can’t use a proxy or multisig to control the funds and therefore a major negative about this option is that funds are held by individuals. One mitigation would be to evenly spread the treasury funds amongst five independent vault operators to reduce centralization.

Pro1: the DOT is not ‘spent’ and can indefinitely provide iBTC capacity.

Con1: a trusted operator must maintain and secure the node running the bitcoin and vault client application where keys are exposed.

Con2: Polkadot treasury DOT would theoretically be at liquidation risk. However, DOT is near an all-time low against BTC, is highly correlated to BTC and therefore extremely unlikely to fall by 60% vs BTC.

We invite the wider Polkadot community to provide feedback whether they would prefer to see a Polkadot Treasury proposal for either Option 1 or Option 2, to suggest tweaks to parameters proposed in the options above, or to suggest other alternative strategies.

Disclosure: I am not an Interlay team member. However, I created this proposal at the urging of the Interlay community and have thoroughly reviewed it with the Interlay community, team, and within ChaosDAO to ensure ecosystem alignment on this initiative.