Redemption Mechanism

A redemption queue is a first-in, first-out (FIFO) system that processes withdrawal requests sequentially to prevent a bank run. This is often paired with a timelock, a mandatory waiting period (e.g., 24-72 hours) between requesting and receiving funds. This design:

• Mitigates panic selling by slowing mass exits.
• Gives the protocol time to source liquidity or adjust parameters.
• Creates a predictable exit process, but introduces liquidity risk for users needing immediate access.

The collateralization ratio (CR) is the value of locked collateral relative to the minted tokens. A healthy CR (e.g., >150%) is essential for redemptions. The health factor is a real-time metric (common in lending protocols) that triggers liquidation if it falls below a threshold (e.g., 1.0). Key risks:

• Under-collateralization: If asset values drop, redemptions may become impossible.
• Liquidation cascades: Forced sales to maintain CR can crash collateral prices, affecting the entire system.

In AMM-based redemption (e.g., swapping a stablecoin for assets in a pool), slippage is the difference between expected and executed price. Large redemptions cause significant price impact, depleting liquidity and yielding fewer assets. This creates a race condition where early redeemers get better rates. Mitigations include:

• Redemption curves that adjust fees based on pool utilization.
• Batch processing to aggregate orders and average price impact.
• Direct vault redemptions bypassing AMMs where possible.

Redemption logic is encoded in smart contracts, making them vulnerable to bugs or exploits. A single flaw can drain the entire treasury. Furthermore, redemptions often rely on price oracles (e.g., Chainlink) to calculate collateral value. Critical failures include:

• Oracle manipulation: Feeding incorrect prices to trigger unjustified liquidations or enable under-collateralized redemptions.
• Reentrancy attacks: Where a malicious contract interrupts the redemption flow to drain funds.
• Governance attacks: If upgradeable, a compromised admin key could alter redemption terms.

In centralized or wrapped asset models (e.g., wBTC, stETH), redemption depends on a trusted custodian or entity holding the underlying asset. This introduces counterparty risk—the custodian may become insolvent, get hacked, or refuse to honor redemptions. Examples:

• Celsius Network: Halting withdrawals led to bankruptcy.
• FTX Collapse: User funds were commingled and unavailable.
• Bridge exploits: Cross-chain redemption bridges are frequent targets for hacks, stranding assets.

Redemption mechanisms may be classified as securities offerings or money transmission by regulators (e.g., SEC, MiCA). This can lead to:

• Enforcement actions forcing protocols to halt redemptions or shut down.
• KYC/AML requirements imposed on users before allowing withdrawals, breaking pseudonymity.
• Geo-blocking of users from certain jurisdictions.
• Asset seizure risk if underlying collateral is deemed part of an unregistered security.

A rebasing token is a type of asset whose supply automatically adjusts to reflect its underlying backing. Instead of a stable price, each holder's wallet balance changes to maintain a constant value share of the collateral pool. This is a common alternative to direct redemption for algorithmic stablecoins.

• Mechanism: The protocol mints or burns tokens from all wallets proportionally.
• Example: Ampleforth (AMPL) adjusts its supply daily based on oracle price deviations from its target.
• Contrast: Unlike a redemption mechanism, users do not initiate a burn to receive an underlying asset; the adjustment is passive and universal.

A burning mechanism is the process of permanently removing tokens from circulation, often a prerequisite for redemption. It is a cryptographic proof of destruction recorded on-chain.

• Function: To trigger a redemption, a user typically sends tokens to a verifiable burn address (e.g., 0x000...dead) or calls a smart contract function that destroys them.
• Purpose: This reduces the token's total supply and serves as the user's claim ticket for the underlying collateral.
• Security: Irreversible burns prevent double-spending of the redeemed asset.

The collateral ratio (CR) is the percentage of a loan's value that is backed by deposited assets. In redemption systems, it determines the health of the protocol and the availability of assets for redeemers.

• Overcollateralized Systems (e.g., MakerDAO): CR > 100%. Redemptions are always possible as long as vaults are liquidated to maintain it.
• Algorithmic/Undercollateralized Systems: CR may fall below 100% during a bank run, causing redemption queues or failures.
• Key Metric: A falling aggregate CR signals increasing redemption risk and potential insolvency.

A liquidity pool is a smart contract containing paired assets that facilitates decentralized trading. For redemptions, it acts as a secondary market exit, often faster than the primary protocol mechanism.

• Secondary Redemption: Users can swap a token for its backing asset (e.g., UST for USDC) directly in an LP like a Curve Finance stablecoin pool.
• Arbitrage: When the primary redemption is slow or costly, arbitrageurs use LPs to profit from price discrepancies, which can help restore the peg.
• Risk: Reliance on LP liquidity introduces slippage and impermanent loss for providers during volatile redemptions.

An oracle is a service that provides external data (like asset prices) to a blockchain. It is critical for determining the value of collateral and triggering automated redemption or liquidation processes.

• Function: Provides the real-time price feed to calculate if a position is undercollateralized.
• Redemption Trigger: In some systems, oracles determine when a redemption right is activated (e.g., when a stablecoin depegs).
• Attack Vector: Oracle manipulation can falsely trigger or prevent redemptions, making decentralized, robust oracles like Chainlink essential for security.

A withdrawal queue is a system that processes redemption requests in a first-in, first-out (FIFO) order when immediate liquidity is insufficient. It prevents a bank run from draining reserves instantly.

• Purpose: To manage liquidity crises by rationing available collateral in an orderly manner.
• Example: Lido's stETH uses a withdrawal queue for unstaking from Ethereum, which finalizes after the chain's withdrawal period.
• Consequence: Creates redemption latency, often leading to the token trading at a discount on secondary markets until the queue clears.