Each stablecoin agreement is a bank, and it is easier to understand how they actually work from the perspective of assets and liabilities.
Written by: Haseeb Qureshi, Managing Partner of Dragonfly Capital
The use of stablecoins surged last year. However, it seems that fewer and fewer people understand how these stablecoins actually work.
For some reason, the creators of stablecoins are obsessed with making these designs seem very complicated and difficult to understand. Almost every white paper is full of equations and new invention jargon, as if the author is trying to convince you: Trust me, you are not smart enough to understand this.
I have a different view on this. After all, all stablecoin designs are very simple. I will show you a simple visual language to help you understand how all stablecoins work.
Think of every stablecoin agreement as a bank. Each family has assets and debts. Each obtains value in some way and distributes that value to holders of “securities”.
Imagine a normal full reserve bank.
On the left is its actual assets, which is the actual physical dollars in the reserve. On the right is its liabilities (called “digital dollars”), which are claims on reserve assets.
In banks with adequate reserves, each liability and reserve assets are matched at a ratio of 1:1. If someone owns digital dollars and requests cash back, the bank will provide the holders with physical dollars and destroy the corresponding digital claims. This is how Tether, USDC, and all other stablecoins backed by fiat currencies work.
The equity of the bank belongs to the shareholders (investors of the bank), and they profit from the fees charged by the bank. Take Tether as an example. The owners of Tether Co., Ltd. are shareholders, and their profits come from Tether’s USDT minting and redemption fees.
Every liability of a full-reserve bank should be closely linked to the U.S. dollar, because it can always be exchanged for 1 U.S. dollar of reserves. As long as banks maintain cheap convertibility, arbitrageurs will ensure that the stable currency is maintained at a pegged exchange rate effortlessly.
This is the original full reserve bank. This is an obvious pattern, but it will help illustrate the difference between crypto banks.
Fully reserve encrypted stablecoin
How would you create a fully-reserve crypto bank with stable debt?
Given that cryptocurrency is just reinventing money, the first thing you need to do is to exchange USD assets for crypto assets. But the price of cryptocurrency is volatile, so if your debt is in U.S. dollars, the 1:1 reserve support ratio will not work. If the price of cryptocurrency drops, the bank will become under-collateralized.
So the thing to do is obvious: increase the encryption buffer, just in case the price of the encrypted currency goes down, so as to provide you with asset buffer protection.
Basically, this is how MakerDAO works.
Dai’s anchoring is currently very stable.
Please note that MakerDAO’s reserve assets are significantly larger than total liabilities (Dai). This can ensure the safety of the entire system.
(I discussed it in more detail in this article , but if you simply compare MakerDAO with other stablecoin models, these are enough.)
Now let’s take a look at Synthetix.
Synthetix takes a different approach: instead of holding a basket of diversified crypto assets, Synthetix issues sUSD stablecoins against a bunch of its own SNX tokens. SNX is also an “equity token”-in other words, the only asset that Synthetix allows as a deposit is its own equity. Due to the high volatility of SNX, Synthetix requires that each sUSD in circulation be 600% over-collateralized.
The anchoring of sUSD is currently robust.
Both MakerDAO and Synthetix are similar to traditional full reserve banks, except that their assets are over-collateralized in cryptocurrencies. To some extent, their anchoring is safe because there is a mechanism to redeem stablecoins as their underlying assets. (In both methods, there is also an interest rate system that targets the desired price.)
But there is another stable currency, usually called the “algorithmic central bank” stable currency.
Algorithmic central bank stablecoins cannot be redeemed at all, and there are no depositors in the traditional sense, which makes them less like traditional banks, but more like central banks. (The central bank tends to use methods other than redeemable rights to maintain price stability.)
Each algorithmic central bank works slightly differently. In order to analyze an algorithmic central bank, we will try to understand its mechanism of action in two important scenarios: stablecoin prices are above the anchor price, and stablecoin prices are below the anchor price.
Algorithmic Central Bank
Structurally, perhaps the simplest algorithmic central bank token is Fei.
Fei’s recent debut has a bad reputation, and almost immediately fell below the issue price. In short, Fei works as follows:
FEI’s anchor price is currently broken.
The operation of Fei is very similar to that of a real central bank, and it can directly defend its pegged exchange rate in the market. Please note that Fei has no meaningful overcollateralization and most of its assets are cryptocurrencies. This means that in the “black swan incident,” Fei’s asset value may be significantly lower than its debt level, and thus cannot defend its anchor exchange rate.
Although the animation above provides you with advanced intuition, it does explain Fei’s real mechanics. Fei uses the Uniswap protocol in all trading activities and uses a technique called “reweighting” to execute its actual transactions. It also uses “direct incentives” (actually a type of capital control).
But the net effect is the same: the agreement participates in the open market to ensure that the value returns to anchor.
A similar algorithm for the central bank is the Celo protocol, which produces a stable currency called Celo Dollar (cUSD). Celo Dollar uses CELO tokens as its reserve collateral (the local asset of the Celo blockchain), and there are also a diversified portfolio of other cryptocurrencies that can be used as collateral.
Like FEI, the Celo agreement has always been willing to use agreements such as Uniswap to buy and sell Celo Dollars in the market. The Celo reserve fund was originally composed of a large number of reserve assets, and hoped that the reserve fund would always remain over-collateralized. If Celo’s assets fall below 200% of its liabilities, the system will try to refinance by charging transaction fees for CELO transfers.
Therefore, the main difference between Celo and Fei (except for their trading mechanism) lies in the assets they hold and the rules surrounding mortgages.
The price anchoring of Celo Dollar is currently very stable.
The third token listed in this broad category is Terra’s UST. It is secured by Luna, the native token of the Terra blockchain. Like FEI and Celo, the Terra protocol acts as a market maker for stablecoins. If the stablecoin system runs out of assets, it will replenish its reserves by increasing the supply of the native token LUNA.
UST’s current price anchoring is very stable.
FEI, Celo and Terra are not allowed to redeem stablecoins as underlying assets. But by making a market for their tokens on the open market (that is, they are willing to buy and sell tokens through spreads).
On the surface, this seems to be very different from convertibility! But this is actually a tighter continuum. This is because a credible commitment to market making is economically equivalent to allowing minting and redemption.
Imagine a stablecoin collateralized by ETH. Suppose they are called STBL tokens. The agreement is always willing to make market on the ETH/STBL trading pair. This means that the agreement will be willing to sell 1 STBL at a price of 1.01 USD ETH and buy 1 STBL at a price of 0.99 USD ETH. If the STBL price is lower than the anchor target, it will continue to exchange STBL until its ETH is used up.
If STBL is replaced by a coin and redemption mechanism, it may allow anyone to cast 1 STBL with a price of 1.01 USD ETH, and then redeem 1 STBL at a price of 0.99 USD ETH. If STBL is lower than the anchor price, it will continue to use STBL to redeem ETH until its ETH is used up.
The net result is the same!
In traditional central banks, the central bank acts as a market maker and does not allow redemption, giving it more discretion. But algorithmic market making is different, because smart contracts can make firm, self-enforcing promises. Therefore, for the two ultimate goals of providing liquidity and ensuring tight anchoring, market making and redeemability are the same.
Now we have studied the “central bank” style stable currency. But there is another weirder algorithmic stablecoin: Seigniorage Shares.
Seigniorage Shares stablecoin
A classic “Seigniorage Shares” stablecoin is Basis Cash, based on its predecessor, Basis, which was not actually issued. This may be a typical algorithmic stable currency, from which many other designs were later derived.
The following is the working principle of Basis Cash (the principle is very long, so it is demonstrated with a video ).
The price anchor of Basis Cash is currently broken.
You can think of Basis Cash as a two-stage operation: When there are outstanding bonds, Basis Cash is in a contraction cycle. Its money supply is not growing fast enough to repay all system debt. But if the demand continues to increase, eventually all bonds will be paid off and the system will enter the expansion cycle. During the expansion cycle, shareholders will again receive the newly minted Basis Cash reward.
The newly minted Basis Cash is the “seigniorage”, that is, the profit made by the central bank through the issuance of new currency.
The normal central bank will keep its seigniorage on its balance sheet to prevent accidents. And Basis Cash will pay all seigniorage taxes to its shareholders immediately after receiving any payment.
As you can see intuitively, this makes Basis a “collateral-efficient” feature. Basis actually has no assets on the balance sheet! This enables it to support a large-scale supply of stablecoins on a zero-asset basis. But this also makes it vulnerable to the effects of a “death spiral” or crisis of confidence, which is actually reflected in Basis Cash.
It is important to understand the operating mechanism of Basis Cash. Later algorithmic stablecoins are the successors of Basis design, including the last stablecoin we will study.
Empty Set Dollar (ESD) is a stable coin issued by the pseudonymous founding team through a fair start. The original version of ESD (now called ESD v1) closely fits the design of Basis Cash.
The price anchoring target of ESD v1 was broken, and they transformed into a new design mechanism. The innovation of ESD lies in the integration of “share” tokens and stablecoins. This means that stablecoins (if pledged) will generate more stablecoins. As you might have guessed, this caused the price of the stablecoin to become highly volatile and drift with the anchor price. Its price was as high as US$2.00 until it eventually fell below US$0.20.
So far, pure Seigniorage Shares tokens have generally failed. Many Basis and ESD counterfeit products such as DSD have encountered the same fate. This at least tells us that the design of stablecoins is really important. These legends should help you reason about why Seigniorage Shares tokens are so susceptible to a crisis of trust.
In the early days of DeFi development, many people believed that decentralized stablecoins were fundamentally impossible. And now it can be said that the above argument is too naive and hastily. There is a lot of design space in the field of algorithmic stablecoins, and some design mechanisms are indeed much better than others.
But one thing is certain: you cannot easily believe that the stablecoin is as solid as a rock just because the project white paper is conclusive. Use your own brain to think more about why stablecoins are stable. (If you are moved and confused, try to draw it. At least for me, this method of drawing is quite helpful.)
Information Disclosure: The Draonfly Fund has invested in a number of stablecoin projects discussed in this article.
Source link: www.8btc.com
