The last week has exposed limits in the current design of Mirror Protocol, with mAsset premiums frequently being 15-25 % compared to the oracle price. Based on the relative performance of the MIR token to the rest of the market, this is hurting adoption and confidence in Mirror Protocol. To restore market confidence we should add a protocol mechanism which will prevent similar mAsset pricing issues in the future. This means we must find a way to fix the underlying issue of supply and demand for mAssets.
This proposal is an attempt to formalize a suggestion made here, taking into account the given feedback as well as highlighting the areas where further discussion may be required. The advantage of this particular solution is that it should be able to dynamically adjust to changing market conditions, bringing mAsset peg stability both in bull markets and bear markets.
Net short: A user has a net short position in an mAsset when the amount of a particular mAsset that the user owns is lower than the user’s current minting balance for that particular mAsset. E.g. A user mints 100 mExample. Of the minted assets the user sells 42, puts 13 in a liquidity pool, burns 37, and holds on to the remaining 8. Since mExample is doing well, after a while the liquidity pool ownership only entitles the owner to 7 mExample, due to impermanent loss. The net short position is then:
shares minted - shares owned or burned = 100 - 7 - 8 - 37 = 48.
An acceptable spread range (ASR) is defined to be ±2 % from the oracle price (or some other suitable percentage value).
Initial reward distribution is a ratio of 80:20 for LP:net shorts (applied to both current LP staking rewards as well as current pool trading fees). 
The average price spread of an mAsset is evaluated against the ASR at regular time intervals.
During evaluation, the reward ratio between net shorts and liquidity providers is re-balanced, increasing one at the expense of the other. With ±2 % as ASR, if
oracle price*1.02 < mAsset price, net short reward is increased. If
mAsset price < oracle price*0.98, net short reward is decreased. If mAsset price is within the ASR, no reward change is made.
Giving exact parameters for how the re-balancing should occur may be hard at this stage since it is likely to be an evolving problem, but three main approaches come to mind.
Option 1, Seeking long-term equilibrium
The time average price spread of an mAsset is evaluated once daily when the main markets are closed (to give the market some time to balance volatility during the day), e.g. 00:00 GMT.
Reward re-distribution happens gradually, e.g. by 4 units every evaluation period. So after the first evaluation period the reward distribution ratio can be 76:24, 80:20, or 84:16, based on the price spread during the first period.
Option 2, Seeking short-term equilibrium
The time average price spread of an mAsset is evaluated every minute.
Reward re-distribution curve is steep. E.g. re-distributing
e^(|price spread percent| - 1)units of the reward every interval when the price spread is outside the ASR (1 % ASR may work better than 2 % here). If the resulting units to be re-distributed is greater than the maximum that can be re-distributed, only the maximum is re-distributed. So if the time average price spread is -4 % during the first evaluation period,
e^(|-4| - 1) = e^(3) = 20 unitswould be shifted to LP giving a reward ratio of 100:0 for LP:net shorts in the next period.
Option 3, Setting the devs free
- We bestow upon the protocol devs the uh… incredible honour of fine tuning the model parameters of a continuously evolving system. They can freely adjust the re-distribution parameters for three months, within the framework given by this proposal. This experimentation period can be extended via future proposals. When the experimentation period ends, the parameter values used during the majority of the last 72 hours of the period are locked in (giving some margin to prevent last minute hacks from interfering).
 The 80:20 starting ratio is a bit arbitrary but basically comes from the fact that a minter has to put in at least 150 % of the capital of a normal buyer of the stock, so if both do LP staking the minter has to put in a total sum of 250 % of the mAssets used (UST + collateral), while a normal buyer can put in 200 % (UST + mAssets). Equal profitability per invested dollar would mean the minter should get 250/200 = 1.25 = 100/80 higher reward, which would come from the minting. Note that there is a lot of handwaving in this argument and in fact the minter would have to lose all mAssets due to impermanent loss for things to actually add up. It is just a starting value though, the important thing is that we start somewhere instead of nowhere.
Topics for discussion
Which of the three options above is the best? Since finding a good solution may require some experimentation to get right I’m personally leaning towards option 3. What we are actually trying to do is to solve a control theory problem, so utilizing methods from that domain such as a PID controller may improve the final result.
There is a possible extension of this proposal for those cases where the mAsset is priced too low, and the reward allocation for net shorts is already at 0. In those cases one could make it even less attractive to be net short by creating a negative interest rate on net short positions. In practice this would mean that the protocol seizes a portion of the collateral for the minted mAssets in question and automatically uses this to increase the size of the UST side of the mAsset pool, so that the mAsset price increases. The problem we have at the moment is however that too few mAssets are being minted and sold to the market, so since this mechanism would make it a bit less attractive to mint, the question is if we still want to add it in now?
Minting an mAsset and then selling it to the market (either directly or by being a liquidity provider) is essentially the same as shorting the asset. It is also the only way to increase the supply of mAssets. In other words, you can only be long in an mAsset if someone else is actively shorting it.
Compare this to the regular financial markets. A company makes an IPO and creates a number of shares that represent ownership in the company. The company does however not provide any collateral apart from this ownership stake. It does not have to add money to its collateral as the share price goes up. Essentially this would be like an mAsset minter not having to adjust the collateral at all . We can thus conclude that the supply of mAssets will be lower than for regular stocks, since the supply side does not have this type of collateral free mint but relies only on short selling.
We know that short interest in most stocks in regular financial markets is a great minority, usually around 4 %. Assuming that the same will also be true for Mirror Protocol, we will have a situation where 4 % of the market will have to supply mAssets to the other 96 %. This will obviously create a supply-demand imbalance and a price premium compared to normal shares.
On top of the above argument, owning an mAsset is generally more attractive than owning the underlying stock. Sure you miss out on dividend and voting rights, but instead you get LP staking with 200-300 % APR, the ability to trade the asset 24/7 and extremely low fees/barriers to entry. It seems natural then that the equilibrium price of an mAsset will be higher than that of the underlying asset, necessitating an extra reward for those with a net short position so supply can keep up with demand.
 This is indeed one of the possible solutions being discussed in the forum, reducing collateral ratio to let minters profitably liquidate their positions instead of increasing the deposited collateral. The problem with this idea is that even with only a 105 % collateral ratio minters will only be incentivized if the mAsset premium to oracle price is greater than 5 %, which is still quite a lot. Also, should the price of an underlying asset suddenly shoot up by 10-20 % (e.g. because of positive news outside of trading hours), the owners of mAssets will lose out on any profit above 5 % since the collateral only covers 105 % of the price.
Here I try to go through the possible risks and risk mitigations I’ve identified for the proposal. Let me know what I missed in the comments.
Someone could try to manipulate the reward distribution in favour of the LPs or net shorts. In practice this is unlikely to be profitable since it requires manipulating the average price while everyone else in the system is working against you, so any profit will be shared with many others while the costs will be borne alone.
If a large part of the LP rewards go to net shorts, the APR for staking will decrease and so liquidity in the pools could suffer. In practice liquidity pool rewards are still likely to be attractive even if 75 % of rewards go to net shorts, since many pools on Uniswap and Sushiswap have rewards around 50-100 % APR for assets which are likely to be far more volatile than those currently on MIR.
Especially for option 2 above, there is a risk that rewards will swing wildly, making the rewards less predictable. This could hurt participation. A solution would be to seek long term equilibrium according to option 1 instead, or to increase the cost of taking short term positions through the use of fees.
If there is a high turnover of minted positions, the 1.5 % protocol fee when closing a minted position could cause governance staking rewards to spike compared to pool rewards, causing low pool liquidity. This could especially be problematic with option 2 above. An easy solution would be to reduce the protocol fee or redistribute some of it to stakers.
During the weekends no new mAssets can be minted, so there is a natural reduction of supply. This could possibly cause spikes in rewards for net shorts during the weekends. Hopefully the market will learn to anticipate this, and keep the impact minimal, but if not, a freeze of some sort to changes of reward distribution when the mAsset cannot be minted could be one way to tackle the issue.