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In order to maintain the peg for the Hue token, a variable interest is charged on Hue debt. This interest can be positive or negative. This means that the Hue debt in a position that a user must pay back to unlock their collateral changes over time. A positive interest rate means the debt increases over time, where a negative interest rates means the debt decreases over time.
The cost/benefit analysis that a position holder must therefore do is what allows variable interest rates to help maintain the peg. If there is a high positive interest rate, a position holder is more likely to want to pay off their position so that they no longer have to pay the interest rate. To do so they need to acquire Hue on the market, which means that the demand for Hue increases and therefore the price.
The opposite is true when there is a negative interest rate. Position holders are likely to want to borrow more to take advantage of the cheap debt, which increases the supply of Hue, decreasing the price.
The protocol does not rely on human judgement to regularly update the interest rate. Instead it relies on the community to tweak the parameters of the simple interest rate update algorithm only as needed to ensure that it is working properly.
The algorithm is simple: every day, for every discrete amount Hue is off the peg up to a maximum amount, the interest rate adjusts in the opposite direction a defined amount. The community can then adjust each of these amounts, as well as the maximum and minimum interest rates until parameter changes are locked one year after launch. After one year, only the interest rate adjustment step size can be changed.
Once the algorithm is fine-tuned and changes are no longer allowed, the protocol will continue to automatically update interest rates without human intervention.
Negative interest rates, meaning paying users to have a position, are novel. This allows the protocol to solve the problem where Hue is over the peg and interest rates are already floored at zero, by further reducing the interest rate and paying users to create a position.
Because it costs gas for a user to call the interest rate update transaction, TCP pays the user who calls the function with TCP tokens. The amount of TCP that is paid is subject to a simple auction mechanism, which pays out more TCP the longer it has been since the function has been called. The starting price for the auction is half of what was paid in the previous update, allowing the amount of TCP paid for an update to reach an efficient market equilibrium.