From Ampleforth, Basis, to ESD, Basis Cash, Frax, a series of Hayek currency experiments that integrate the paradox of reflexivity and stability.
Written by: Benjamin Simon, Researcher at Mechanism Capital Compiler: Perry Wang
The English version of this article was published in Deribit Insights. The author and Deribit authorized the translation and published its Chinese version.
There are two academic papers published in 2014 that are worthy of attention: one written by Ferdinando Ametrano , a professor at the Politecnico di Milano, who was once the project leader of the Bitcoin Developers Conference. The title is “Hayek Currency: A Solution for Cryptocurrency Price Stability” “(Hayek Money: The Cryptocurrency Price Stability Solution); another article, written by Robert Sams , a cryptocurrency economist with 11 years of experience in hedge funds, is titled “Cryptocurrency Stabilization: Seignorage Shares” (A Note on Cryptocurrency Stabilisation: Seigniorage Shares).
Drawing on economist Friedrich Hayek’s criticism of the gold standard, Ametrano believes that due to its deflationary nature, Bitcoin cannot fully perform our requirements for the function of currency as a unit of account. Instead, he proposed a rule built on, money supply elasticity of encryption, can be made “on behalf of the money supply changes” (rebase) on demand, for example, in proportion to changes in the money supply all tokens holders.
In the paper ” Seigniorage Shares “, Sams proposed a similar model based on similar reasons, but with an important adjustment: Sams’s system does not re-adjust the supply of tokens, that is, change the currency allocated in all wallets proportionally. supply, but by two tokens: the elasticity of the money supply itself, and network investments “share.” After the owner of a property (Sams called Seigniorage Shares), it is the sole recipient of the supply increase caused by inflation gains, while shrinking the demand for money and the contraction of the network, is the only bearer of debt.
Savvy cryptocurrency observers will immediately realize that Ametrano’s ” Hayek Currency ” and Sams’s “Seigniorage Shares” are no longer purely abstract academic concepts. “Hayek Currency” is almost identical to Ampleforth . Ampleforth was launched in 2019 and soared in July 2020. Its fully diluted market value has exceeded US$1 billion. Recently, Sams’ Seigniorage Shares model has become the theoretical basis of Basis, Empty Set Dollar, Basis Cash and Frax to varying degrees.
Now, the problem before us is no different from the problem faced by their readers when Ametrano and Sams published their paper 6 years ago:
Algorithm stable currency can truly achieve long-term viability?
Will algorithm stable currency will always be subject to extreme expansion and contraction cycle?
Which version of the algorithmic stablecoin is more compelling: a simple rebasing model, a multi-token ” Seigniorage Shares ” system, or something completely different?
On all these issues, the popular jury has not yet reached a verdict, and it may take some time to reach a broad consensus. Nevertheless, we still try to approach from the first principle of reasoning, as well as some empirical data in recent months, explore some basic questions.
Stable currency background
Algorithmic stablecoin itself is an independent world, but before in-depth study, it is worth taking a step back and discussing the broader stablecoin landscape
With Bitcoin’s snowball adoption by financial institutions, the hot market for decentralized financial DeFi, coupled with the upcoming network upgrade of Ethereum, stablecoins have also become popular recently, with a total market value of more than $25 billion. This parabolic growth has attracted the enthusiastic attention of bigwigs outside the cryptography circle, and recently even attracted the attention of a group of US congressmen.
USDT is still the top stable currency in the current market share, but it is by no means the only stable currency. Broadly speaking, we can be divided into three categories stable currency: the US dollar to stabilize the currency mortgage, multi-asset pool over-collateralisation stable currency and a stable currency algorithm. The focus of this article is on the last category. However, it is important to pay attention to the advantages and disadvantages of other types of stablecoins, because understanding these compromises will allow us to enhance the value proposition of algorithmic stablecoins.
The first stable currency (mainly USDT and USDC, but also including stable currency exchange issue, for example BUSD, HUSD, etc.) belongs to the center management to support the dollar, and you can use 1: 1 exchange rate. These stablecoins have the advantages of ensuring anchoring and high capital efficiency (that is, no over-collateralization), but they require permission and are centrally managed. These properties mean that users may be blacklisted and exchange rate anchored itself depends on centralized entities trustworthy behavior.
The second category is multi-asset mortgage stablecoins, including MakerDAO’s DAI and Synthetix’s sUSD . Both stable currency assets of over-collateralisation by encryption, and both rely on price oracle to maintain the dollar anchor. Unlike centralized tokens such as USDT and USDC, the second stablecoin can be minted without permission. However, it is worth noting that in the DAI use case, licensed centralized assets such as USDC can be used as collateral. In addition, the nature of the over-collateralization mechanism of the second stable currency means that the capital is too dense, and the highly volatile and highly correlated nature of encrypted assets makes these stable currencies vulnerable to the impact of the entire encrypted market in the past.
All these make us pay more attention to algorithmic stablecoins. Deterministic algorithm is based on a stable currency mechanism (ie, using an algorithm) to adjust its supply of tokens, tokens are designed to make the price move in the direction of the target price.
Simply put, algorithmic stablecoins will expand their supply when they are above the target price, and shrink the supply when they are below the target price.
Unlike the other two types of stablecoins, algorithmic stablecoins cannot be exchanged with the US dollar at a 1:1 exchange rate, and there are currently no encrypted assets as collateral. Finally, and perhaps most important point is that the algorithm is stable currency usually has a high degree of reflexivity: demand is largely driven by market sentiment and momentum (critics may object). These demand-side forces are transferred to the token supply, which in turn generates further directional momentum, which may eventually form a violent feedback loop.
Each stablecoin model weighs its pros and cons. Investors who don’t care much about the impact of centralization will not think that there is something wrong with USDT and USDC. Others will feel that overcollateralization with inefficient capital is a price worth paying in exchange for unlicensed, decentralized, hard-anchored currency. But for those who are not satisfied with these two options, algorithmic stablecoins are an attractive option.
The paradox of reflexivity and algorithm stability
Algorithm stable currency in order to achieve long-term viability, stability must be achieved. For many algorithmic stablecoins, this is a particularly difficult task due to its inherent reflexivity. Changes in the supply of the algorithm is based on counter-cyclical policies; expand the supply designed to reduce the price, reduce supply to raise prices. However, in practice, the supply will usually change momentum by zooming direction reflexivity, especially for algorithmic pattern does not follow the “seigniorage shares” mode. In the seigniorage shares model, the stablecoin token itself and the token that accumulates value and debt financing are two independent tokens.
For non-algorithmic stablecoins, network guidance does not involve game theory coordination. Each stablecoin (at least in theory) can be exchanged for equivalent dollars or other forms of collateral. By contrast, the success of the price stability of the algorithm is completely stable currency can not be guaranteed, because it is completely determined by the collective market psychology.
Haseeb Qureshi, managing partner of Dragonfly Capital, aptly pointed this out: “These mechanisms use a key insight: the stablecoin is ultimately a Schelling point. If enough people believe that the system can survive, then this This belief will bring a virtuous circle to ensure its survival.”
In fact, if we consider more carefully the algorithm is stable currency long-term stability what it takes, we will find an apparent paradox. In order to achieve price stability, algorithmic stablecoins must grow to a large enough market value so that buying and selling orders will not cause price fluctuations. However, pure algorithm stable currency grow to a large enough size of the network is the only way through speculative trading and reflexivity, reflexivity and high growth problem is that it is not sustainable, and the contraction usually have reflexivity. Therefore, the paradox arises: the larger the network value stable currency, it faces massive price shocks of greater elasticity. However, only highly reflexive algorithmic stablecoins, that is, those coins that are prone to extreme expansion/contraction cycles, can first obtain a great network valuation.
Bitcoin has a similar paradox of reflexivity. In order for more and more people and organizations to use Bitcoin, Bitcoin must have increasing liquidity, stability and acceptance. Over the years, these features Bitcoin growing, allowing users to Bitcoin from the initial dark net participants, all the way extended to subsequent rich technical personnel, as well as the recent traditional financial institutions. At this point, Bitcoin has received resistance from deep reflexive cycle, this is the path algorithm stable currency also need to follow.
Ampleforth: a simple but flawed algorithmic stablecoin
Now let’s turn our eyes from abstract theory to the real world of algorithmic stablecoins . First, start with the largest but simplest protocol in existence: Ampleforth .
As mentioned earlier, Ampleforth is almost the same as the ” Hayek currency ” proposed by Ferdinando Ametrano. The supply of AMPL expands and contracts according to the deterministic rule based on the daily time-weighted average price (TWAP): below the price target range (for example, less than $0.96), the supply shrinks, and above the price target range (for example, high At US$1.06) then the supply will increase. It is essential that each wallet “participates” in proportion to each supply change. If Alice held 1,000 AMPL before the rebase and the supply increased by 10%, Alice now holds 1,100 AMPL; if Bob owns 1 AMPL, then he now owns 1.1 AMPL.
The ” rebase ” covering the entire network is the difference between the algorithm model of Ampleforth and the seigniorage share model adopted by other protocols. Although the Ampleforth white paper does not explain the basic principles of using a single-token rebasing design rather than a multi-token approach, the design decision seems to have two main basis.
- The first is simplicity. No matter how it works in practice, Ampleforth’s single-token model has an elegant simplicity that other algorithmic stablecoins cannot match.
- Secondly, Ampleforth single token design is known as the most stable currency fair algorithm mode.
In sharp contrast to the policy actions of fiat currency, the policy actions of fiat currency benefit those individuals who are ” closest ” to the source of the currency the most (the “Cantillon effect”). The design of Ampleforth allows all currency holders to rebase after each rebase. Can keep the network share it holds unchanged. Ametrano pointed out this in his 2014 paper. He detailed the “serious unfairness” of the central bank’s monetary policy behavior and compared it with the relative fairness of “Hayek currency.”
This is the presumption principle of the Ampleforth model, which has been replicated by other algorithmic stablecoins (such as BASED and YAM) that use the rebase principle. But before discussing the shortcomings of this model, we may first look at the data we have about Ampleforth’s performance for one and a half years.
Since mid-2019 (just over 500 days so far), three-quarters of Ampleforth’s daily rebase are positive or negative. In other words, more than 75% of AMPL’s TWAP since its launch has exceeded the rebase target range. To be sure, the agreement is still in its infancy so far, so it is too early to deny it for these reasons alone. However, we will soon study how the modified seigniorage stablecoin Empty Set Dollar can maintain the stability more than twice that of Ampleforth in the first few months of its birth.
Ampleforth’s diehard fans often dismiss the token’s lack of stability; many of them even hate the label of “algorithmic stablecoin”. Their argument is that it is enough for Ampleforth to become a “reserve asset that has no correlation with traditional financial assets” in portfolio diversification.
But this statement is questionable. For example, a cryptocurrency is rebase daily based on a random number generator. Like Ampleforth, the token will have a “significant volatility footprint”, but it is not valid to say that it has value for this reason alone. Ampleforth value proposition depends on its tendency towards equilibrium, balanced in theory, can become AMPL pricing currency.
But will it? Imagine if Ampleforth got rid of its “difficult” characteristics so far, and completely transferred its price fluctuations to supply fluctuations, so that the price of each AMPL would basically remain stable. Is this “mature” Ampleforth really an ideal choice for trading base currencies?
The crux of this we have to discuss the problem, and the core of the design defects Ampleforth: AMPL process even if the price reached $ 1, AMPL purchasing power held by individuals will reach $ 1 in constantly changing. As early as 2014, Robert Sams clarified this exact question regarding Ametrano’s Hayek currency concept:
Price stability not only to the stable unit of account, but also related to the stability of monetary value stored. Hayek currency aims to solve the former, not the latter. It just replaces the fixed wallet balance and fluctuating currency price with a fixed currency price and fluctuating wallet balance. The end result is that the purchasing power of the Hayek wallet is as unstable as the Bitcoin wallet balance.
Eventually, the simplicity of Ampleforth (its simple single token rebase mode) has become a loophole, not features.
AMPL token it is a speculative tool, when inflation is high demand by holding cash reward its people, and in the low demand is forcing them to hold out people to become debt financiers. Therefore, it is difficult to see how AMPL can achieve both speculative purposes and the stability necessary for stablecoins.
Multi-token “seigniorage” plan
Robert Sams’s “Seigniorage Shares” vision never become a reality, but the recent emergence of a number of new algorithms stable common currency project with a lot of core components therein.
Basis Cash, which was born just over a week ago, is an open attempt to revive Basis. Basis is an algorithmic stablecoin project that raised more than $100 million in 2018 and was highly praised, but it has not been launched. And as Basis, Basis Cash is a multi-token protocol, composed of three tokens: BAC (algorithm stable currency), Basis Cash Shares (which hold out can earn money from inflation BAC at the time of network expansion) and Basis Cash Bonds (can be purchased at a discount when the network is in contraction, and can be exchanged for BAC when the network is out of deflation). Basis Cash is still in the early stages of development and has encountered some early development obstacles; the agreement has not yet made a successful supply change.
But another project like Seigniorage Share Empty Set Dollar (ESD) has been active since September, and has gone through multiple cycles of expansion and contraction. In fact, ESD has reached more than 200 supply epochs (one every eight hours) so far, of which nearly 60% of the changes, the TWAP of ESD is within the range of $0.95 <x <$1.05, which means that the price stability of ESD has been It is more than twice that of Ampleforth, although the life span of ESD is much shorter so far.
At first glance, mechanism design ESD seems to be a mixture of Basis and Ampleforth. Similar Basis (and Basis Cash), ESD use of bond (coupon coupon) to finance agreement debt, bonds must be purchased through burned ESD (thus causing reduction in supply), and can be restored after the supply of the extended money back into ESD in agreement. But unlike Basis, ESD does not have a third token that is rewarded from inflation when the network pays off debts and enters expansion. Instead, ESD holders can ” bind ” (such as pledge) their ESD in the ESD decentralized autonomous organization DAO, thereby distributing the benefits of inflation proportionally, similar to Ampleforth’s rebase.
Crucially, the unbound ESD from the DAO requires a ” temporary storage ” period, in which ESD tokens are temporarily “temporarily stored” for 15 epochs (5 days), during which they can neither be traded nor obtained by their owners Inflation rewards. Therefore, the “temporary storage” mode function of ESD is similar to Basis Cash Shares , because binding ESD to DAO and purchasing Basis Cash Shares presuppose risks (liquidity risk of ESD; price risk of BAS) in exchange for future inflation rewards potential. Indeed, despite the use of two tokens mode ESD (ESD and coupons) instead of three generations Basis Cash currency mode, but the staging of the final result of ESD ESD is turned into a de facto three generations currency system, similar to the binding of ESD At Basis Cash Shares.
Comparison of single-token and multi-token algorithm stable coin models
Obviously, compared with Ampleforth’s single-token rebase model, the multi-token design contains more change components. However, this increase in complexity is only a small price to pay for the potential stability it provides.
In short, the ESD design patterns and Bass Cash used, the advantage is to curb the inherent reflexivity system, and “stable currency” is part of the system (in a way) to achieve the isolation and kinetic energy market. Speculators who prefer risk can guide the agreement during the contraction of the money supply in exchange for the future distribution of benefits from the recovery and expansion. But in theory, users who only hope to have stablecoins with stable purchasing power can hold BAC or ESD without buying bonds, coupons, stocks, or binding their tokens to DAO. This lack of rebase adds the additional benefit of combining with other DeFi primitives. Unlike AMPL, BAC and (unbound) ESD can be mortgaged or loaned without having to consider the complex kinetic energy of token supply changes in the entire network.
Evan Kuo , founder and CEO of Ampleforth, criticized algorithmic stablecoin projects like Basis Cash because they “rely on the debt market (such as bonds) to regulate the supply of tokens.” Kuo advise people to stay away from these “zombie ideas” because these algorithms stable currency like the same as traditional markets are flawed, they “will always depend on the final lender (for example, rescue bailout).”
But Kuo’s argument is an argumentation question because it assumes that relying on the debt market (bailout) is inherently dangerous without any valid reason. In fact, debt financing in traditional markets is problematic due to moral hazard. Business entities that are “too big to fail” can take huge risks without worrying about being punished by socializing the cost of assistance. Algorithmic stablecoins like ESD and Basis Cash do not enjoy the luxury treatment of Fannie Mae and Freddie Mac during the 2008 financial tsunami. For these agreements, there is no lender of last resort outside the system (that is, the last recipient of the rescue cost). ESD or Basis Cash is entirely possible to grow into a debt spiral, in this spiral of debt accumulation and no one wants to then set the debt, the collapse of the related agreement.
In fact, Ampleforth also requires debt financing to avoid a death spiral. The difference is that this debt financing is hidden in full view, because it is only distributed among all network participants. Unlike ESD and Basis Cash, if you do not act as an investor in the agreement, you cannot join the Ampleforth system. Holding AMPL when the network is in a contracting state is similar to taking on the debt of the network (“acting as a central bank” according to Maple Leaf Capital), because AMPL holders will lose tokens in each negative supply rebase.
From both first-principles inferences and empirical data, we can conclude that compared with the “single-token rebase” solution, the multi-token, “Seigniorage Shares” inspired model has significantly higher built-in stability . In fact, Ferdinando Ametrano recently updated the Hayek currency “first simple realization concept” he personally proposed in 2014. In view of the above problems, he now supports the model based on multi-tokens and Seigniorage Share.
However, even if multi-token algorithmic stablecoins are better than their single-token counterparts, there is no guarantee that any of these algorithmic stablecoins will continue to develop in the long term. In fact, the basic mechanism design algorithm stable currency excludes any such guarantee, as described above, stability, stable currency is ultimately algorithm based on game theory of reflexivity coordination phenomenon. Even for agreements like ESD and Basis Cash that separate trading, purchasing power stability tokens from value accumulation and debt financing tokens, the stablecoins can remain stable only if investors are willing to guide the network when demand drops. When there are no longer enough speculators to believe that the network is resilient, the network will no longer be resilient .
Partially reserve stablecoins: a new era of algorithmic stablecoins?
The speculative nature of pure algorithmic stablecoins is inevitable. However, some prototype agreements have recently emerged, trying to use partial asset mortgages (“partial reserves”) to control the reflexivity of algorithmic stablecoins.
The view on this issue is simple. Haseeb Qureshi’s observation is correct: “Fundamentally speaking, it can be said that the “mortgage” supporting Seignorage Share is a share in the future growth of the system.”
So, why not use actual collateral to supplement this speculative “collateral” and make the system stronger?
ESD v2 and Frax did just that. ESD v2 is still in the research and discussion stage, after which it will finally decide its fate through governance voting. If implemented, this upgrade will make several substantial changes to the current ESD protocol. The most important of these is the introduction of ” reserve requirements .”
In the new system, the ESD agreement will consider a reserve ratio of 20% to 30%, initially priced in USDC. Part of these reserve funds comes from the agreement itself, which will sell ESD on the open market when the ESD is higher than a certain target price, and part comes from ESD holders who want to unbind from the DAO (they must deposit in the reserve). Then by automatically purchasing ESD until the minimum reserve requirement is reached, these USDC reserves can be used to stabilize the agreement during the network contraction.
Frax, which has not yet been released, is a more elegant attempt to create a partial mortgage algorithm stablecoin. Like Basis Cash, Frax includes three tokens: FRAX (stable currency), Frax Shares (governance and value accumulation tokens) and Frax Bonds (debt financing tokens). However, unlike all other algorithmic stablecoins discussed above, FRAX can always be minted and redeemed at a price of 1 USD, which means that arbitrageurs will play an active role in stabilizing the price of the token.
This casting / Frax exchange mechanism is the core of the network, because it takes advantage of the dynamic part of the reserve system. To mint a FRAX token, users must deposit a certain combination of Frax Shares (FXS) and other collateral (USDC or USDT), which is worth one U.S. dollar. The ratio of FXS to other collaterals is determined by FRAX’s demand dynamics. As demand increases, the ratio of FXS to other collaterals will increase. Locking in FXS to cast FRAX has a deflationary effect on the supply of FXS. Therefore, as more FXS is needed to cast FRAX, the demand for FXS will naturally increase as the supply drops. On the contrary, as Frax’s document points out, during the network contraction, “the agreement re-collateralized the system, allowing FRAX redeemers to get more FXS and less other collateral from the system. This increases The collateral in the system accounts for the proportion of FRAX supply. With the increase in FRAX support, the market’s confidence in FRAX has also increased.”
Effective, dynamic and stable mortgage acts as a counter-cyclical mechanism to Frax agreement can passivate the harmful effects of extreme reflexive when needed. However, the possibility of the agreement becoming completely unsecured in the future is retained, as long as the market makes this choice. In this sense, Frax’s dynamic mortgage mechanism is “operable under any circumstances.”
Both Frax and ESD v2 are not yet online, so it remains to be seen whether they can succeed in practice. But at least in theory, these hybrid, is reflexive and stability combined with a promising attempt to reserve part of the agreement requires, while still more capital efficient than DAI and sUSD such as over-collateralisation scheme.
to sum up
Algorithmic stablecoin is a very attractive currency experiment, and its success is inevitable. Although Charlie Munger (Charlie Munger) motto has always been overwhelming: “Tell me, I should tell you the results,” but the complexity of these agreements have on game theory, a priori reasoning alone can not fully grasp. In addition, if the past crypto market cycle can be used as a reference, we should prepare for these dynamics and promote its success with rational expectations.
It would be foolish to kill algorithmic stablecoins at such an early embryonic stage. It is also wrong to forget how high the risk is. Economist Friedrich August von Hayek wrote in his 1976 masterpiece “currency denationalization” (The Denationalisation of Money) in: “I believe that gold can be in human history than Do it better. The government cannot do better. Free enterprises, such as institutions that stand out from the competition, can undoubtedly provide good currency, and they undoubtedly will.”
Although the algorithmic stablecoin is still in its immature state, it may eventually become Hayek’s blueprint for the money market vision and lay the foundation for it.
Interests: The author of this article may hold a position in the tokens mentioned in the article.
