Reversible Call Options (RCOs)

Instead of the traditional liquidation process where the collateral is sold off, RCOs introduce reversible call options. Here, external parties, referred to as "supporters", can intervene by providing additional collateral to the unhealthy borrowing position, effectively topping it up. This action is incentivized by giving supporters the rights similar to a call option on the collateral. The reversible call option allows the supporter to acquire the right to buy the collateral at a later date (maturity of the option), but with the added twist that the option can be terminated by the option seller at a premium before reaching maturity. This provides a flexible mechanism where the original terms can be adjusted or terminated based on the market conditions.

Process Flow:

• Initialization: When a borrowing position becomes unhealthy, a supporter can step in and provide additional collateral, buying a reversible call option.

• Pre-Maturity Phase: Between the time of option purchase and its maturity, the borrower can either restore the health of the borrowing position by themselves (by adding collateral or repaying part of the debt) or allow the supporter’s option to move towards maturity.

• Maturity: If the position has not been restored to health by the maturity date, the supporter can execute the option, acquiring the collateral. Alternatively, if the market conditions have improved or the borrower has improved the position's health, the supporter can opt to terminate the option early, receiving a premium for the early termination.

Benefits:

• Reduced Liquidation Spiral Risk: By allowing positions to be topped up rather than liquidated, RCOs reduce the probability of a liquidation spiral where the selling of collateral depresses prices and triggers further liquidations.

• Increased Stability: The mechanism offers a buffer against rapid market downturns, giving borrowers more time to address their position's health.

• Profit Opportunities for Supporters: Supporters are incentivized by potential gains either from premiums for terminating the option early or from profits if they execute the option at maturity when the collateral's value exceeds the debt.