About the author: 25 years of experience as a derivatives trader in some of the biggest investment banks. Trading Crypto full-time since 2015.
PegNet is an application built on Factom which is live now on mainnet but in very early stage. At the time of writing, PegNet market cap is below 400,000 usd as seen here https://pegnetmarketcap.com/
Factom main chain has itself lost a lot of steam since the crypto market peak in early 2018. It was an early player and used to be a top10 coin but dropped below the top100 with its daily volume of its token FCT around a mere 50,000 usd as of writing. PegNet is the latest attempt to try to revive interest into Factom blockchain and its ecosystem.
Both Factom and PegNet are decentralized projects now but both still have strong links with Factom Inc, a private company whose CEO Paul Snow is the main architect of both Factom (the blockchain) and PegNet.
The purpose of this article is to provide criticism to how PegNet is designed. In its current state, PegNET is too insignificant anyway so those critics don’t matter but I want to demonstrate the flaws in design should one day something like PegNet reach a bigger size.
It is mainly addressed to those who already have some understanding of how PegNet works
For more information about Factom or PegNet, visit https://pegnet.org/ and factom.com. The whitepaper is available here https://pegnet.org/docs/whitepaper.html
PegNet essential promise is to provide a decentralized network of pegged (pXXX) tokens on top of Factom which replicate the performance of whatever tradable XXX asset.
I will try to summarize the main features of PegNet first
pXXX Tokens are created by burning the native token of PegNet PEG and conversely pXXX tokens can be burnt converted back inside the system into freshly minted PEG tokens. The conversion rate is determined by oracles who are incentivized to provide a truthful rate as can be observed on exchanges. The white paper describes an arbitrage mechanism ensuring that pXXX tokens trade very near the price of the underlying XXX asset. One of the essential assumption is the PEG token itself has some value and liquidity against USD and that the quoted pXXX/PEG rate will be thus determined such that pXXX/PEG * PEG/USD is very near XXX/USD so that pXXX is very near XXX.
Of course it is also possible to exchange pXXX between outside of the PegNet system if a buyer and a seller agree to transact together.
Its designers are publishing a lot of “proofs” and examples that the design works and that by design, the pegged tokens should will always trade near the underlying asset and that for example a stable-coin can be generated this way.
I will divide the main discussion in two parts. In the second part i will explain in detail how to game the system, in the first part i will provide some intuition as to why the system is flawed.
Some intuitions
The first important observation is that for the system as a whole, it is possible only to cash out of the pXXX tokens by redeeming them for PEG first and in a second step, selling PEGUSD on external exchanges.
I am not talking about a single individual wanting to sell his pXXX to another one on an external exchange but about the possibility for everyone to cash out at the same time, or the possibility for a single owner of the whole supply of some pXXX token for which nobody else has interest to cash out.
PegNet devs argue that its always possible to cashout little by little pXXX because 1) there is always a bid on PEGUSD (strong assumption but let’s make it.) 2) at any moment both the market price and reference conversion price pXXX/PEG will be close to the (pXXX/USD)/(PEG/USD) ratio because of arbitrage activity. So even if the liquidity is low in PEG/USD compared to volume one has to sell to cash out in pXXX tokens, one can repeat “hit the PEG/USD bid at the same time than hitting the (pXXX/PEG) bid” enough times and in some finite time one will have sold off his position.
PEG is valuable because, according to the whitepaper, it “serves as a relief valve to the protocol” and “demand for PEG will be driven by arbitrage and scarcity, as it never has to be liquidated as PEG on the markets. Both FCT and PEG will serve as gateways into the PegNet. FCT when the market is growing, and PEG if the market contracts or is stable for the PegNet.”
Please pause and think deep about this construction and their arguments. Does it make sense ?
- In essence they are saying, if you have a big size of some stuff to sell, you will always be able to sell it because look there is a bid for a small size of stuff, so there will be always one who will bid next and you will end being able to sell all your stuff. Note that the argument would work for ANY stuff, and doesn’t apply just for PegNet tokens. It is specious and recalls of snake-oil selling techniques !
I could create my own GB tokens, always provide a quote for a small size against PegNet’s pegged tokens, and claim that necessarily the GB tokens must hold some utilitarian value !
The uniqueness of PEG relies entirely on it being the token used in the conversion mechanism, which causes a whole set of problems as seen below. - what if the size to be sold on pXXX is really too big compared to the available liquidity on PEG/USD ? Even if it is not the case today, it may happen if XXX goes up a lot in price (for example XXX is the SPX and triples in price) and PEG doesn’t go up in price and its liquidity stay the same. Then as one tries to cash out, PEG price goes in a down spiral and probably as bids keep getting hit without any care for the price, market for PEG goes bidless.
- Why would anyone buy and hold PEG for any reason ? If you want to arbitrage the peg between pXXX and XXX you just need to buy PEG/USD when an arbitrage opportunity is available and buy PEG/USD at (almost) the same time you buy pXXX/PEG or do a conversion in the system. it is the same if you want to buy a pXXX asset. When one is aware of the system’s weakness and that PEG can flash crash anytime (or flash smash if there was sudden demand for a pXXX token) it is insane to take a position on it. Because no one but naive people want to hold it, the price should go down (to 0). This argument is similar to the velocity problem from which suffer a lot of tokens.
- PEG price and its liquidity (the higher the price in practice its very likely the liquidity would be higher as well) support all the assets on the PegNet system. but there is absolutely no mechanism which ensures that the price of PEG increases in line with the market cap of the pegged tokens. People get tokens by burning PEG. but if said token value increase in price because the underlying assets go up in price (BTC moons ! SPX rockets higher !) all else being equal, including PEG price and liquidity, PEG will have a harder time to support a bigger token base as some people cash out. In some sense when you are betting for token prices for going up, when it happens you are hoping that the PEG system becomes more fragile !
How can the existing PEG magically support the increase (for external reasons) of the prices of assets ? In some way, the system becomes “undercollaterized” although PegNet designers may hate to say that PEG is a collateral and don’t want critics to view PegNet as an ETF. - When people cash out, because the asset base has gone up, PEG tokens are created (and pXXX tokens burnt). PEG holders thus get diluted and it is natural the PEG price will go down. Again, it shows betting for tokens is betting against the platform. but then aren’t you taking a risk of not getting your payout… indeed (think about it, and read the rest)
- In some sense there is no free lunch. you can’t have a peg without giving up something or it would be magic. its a bit like Heisenberg principle, if the peg exists and there is no deviation from the peg (=position), then the volatility (= velocity) of the price of PEG token is very high.
- given the above why would anyone participate in the PegNet system ? if you have 2 assets A and B which have the exact same characteristic but one or two where A is inferior to B. Why would anyone buy A at the same price than B ? of course A must command a lower price than B else there would be no demand. a pegged token is just (a failed attempt at) financial engineering ! so there is a case for an pegged tokens to trade below the peg because they behave like the original but with much lesser liquidity than the original. but thats not all. Even if there is an initial discount, if you buy below the peg at a discount but still resell it at the same discount, there is still no incentive to participate in the scheme and buy any pXXX token.
Gaming the PegNet
I hope the reader will have already formed at this stage some doubts. But the arguments above are of theoretical or heuristic nature, i will concede they may not be decisive yet. So let’s go to the second part and how to game the PegNet and profit from their system.
Before going into the details, the crux of the idea for gaming the system is to do liquidity arbitrage (as opposed to price arbitrage). There is no apparent contradiction in the PegNet construct when we are dealing with small transaction sizes but the logic of the whole scheme fails when we deal with big sizes, which is all what liquidity is about.
- Designers of the PegNet arrive at the conclusion that thanks to arbitrage activity, we have as result the strong arbitrage property that pXXX trade near XXX price, or in other words with very little discount. I will deny that later, but it will help the discussion that we have the weak arbitrage property that all tokens trade at (nearly) the SAME discount. Indeed, if a pXXX token has a bigger discount than the pYYY token, arbitragers can sell their pYYY token into pXXX token, hedge the exposure on external markets and then lock a profit.
- By the way, we have already an example of weak “arbitrage” in the crypto market with Tether (USDT). there can be a discrepancy between BTCUSD and BTCUSDT on Tether (Binance, BitTrex, Poloniex, BitFinex etc…) and non-Tether exchanges (Coinbase, BitStamp, …), but usually the percentage difference is the same than between ALTUSD and ALTUSDT as the quoted ALTBTC price is the same on all exchanges, Tether or not. In other words all coins have the same discount on the Tether exchange, which is the discount of the Tether USDT token itself.
- It will simplify the rest of the discussion that there is only one token of the PegNET, pUSD a “stablecoin” pegged to 1USD.
- Now to illustrate the discussion lets assume that we have 100 million of PEG tokens in circulation and 50 million pUSD tokens in existence, and that the current price of pUSD/USD on external exchanges is 0.995/1.005 (bid offer) 50k x 50k on each side and that are sporadic trades going on at 1.00 such that PegNet conversion rate is 1.00 . the current price of PEG/USD on external exchanges is 0.0995/0.1005 (bid offer) 100k x 100k on each side
Because of arbitrage pUSD/PEG market is 9.99/10.01 50k x 50k and the conversions pUSD/PEG are available with a 10:1 ratio in the PegNet system. - The market cap for PEG tokens is 10 million USD and the market cap for pUSD is 50 million USD in this example.
50K each side is the regular liquidity on PEG/USD, and 100k the regular size on the PEG token.
These numbers are out of (almost) nowhere just for illustration. I chose them looking at the order book for USDT on Kraken to make it in the same order of magnitude relative to the market cap for Tether with bids and offers for 0.1% of the market cap in a 1% band from the current price. - Now suppose that PegNet works as its creators intended it. There is some activity going on the network, all users believe the peg works for real, there are an ecosystem with arbitragers, a vibrant community on SNS, including a Discord and Reddit of holders of PEG tokens, and a pUSD token actively used on exchanges, apps , payments or whatever, as an alternative to Tether.
- Now we have our trader called GB who has quite a lot of capital (say 20 million USD), and whose strategy is the following. Buy 100K USD worth of PEG at regular interval at the prevailing price until all money is spent (and GB buys all existing PEG) or more realistically with spending only a few millions PEG price shoots up and triples reaching 0.3 as sellers don’t understand why the market is FOMOing so much and retreat their offers. Of course GB tries to act as he is not the only buyer so as not to not raise too much suspicion and he can accumulate as much PEG as he can.
- GB is acting like a “pump and dumper”. Pumping is easy and it is a success. Let’s say GB managed to buy 10% of the PEG in circulation aka 10 million PEG tokens, having spent 2 million USD in total. Indeed GB bought PEG from 0.1 to 0.3 USD per token with an average price of 0.2 USD per token. PEG price is indeed now above 0.3 from 0.1 when he started buying. He is sitting on 1 million USD paper profit based on screen prices. But how can he cash out to real USD without causing the PEG price to crash before he can sell it all at a profit ?
- The answer is to use the conversion scheme ! and burn all his 10 million PEG tokens and acquire pUSD tokens. The oracles (PEG miners) will look at the current price of the market. Because of arbitrage activity it will look something like this.
PEG/USD 0.295 / 0.305 100Kx100k and pUSD/PEG is now 3.3303/3.3363 50x50 so that the conversion rate is 3.3333:1 in the PegNet system - thanks to the conversion scheme GB will obtain 3 million pUSD token and burn 10 million PEG tokens. [only 90 million PEG tokens are in circulation now]
- Now GB hits the bid from PS , a PegNet enthusiast, who had been waiting for weeks or months with his hidden bid for 1 million on pUSD (by clips of 50k) at 0.99 per token on some external exchange. but GB is not satisfied, he is nervous and doesn’t trust PegNet at all and he wants to cash out as quickly as possible before the market realizes what is going on, and wants to see more bids on pUSD but there is now no bid at 0.99. Arbitrage traders have never seen a 1% arbitrage available and retreat prudently their bids at 0.985 for 50K . They are surprised when GB hits their bids for 50k, they put in some more bids at 0.985 but keeps getting hit so they retreat their bids again at 0.98. of course GB has still a couple millions of pUSD to sell and he is sitting on nice profits so he keeps hitting the pUSD bids lower and lower until he sells the last bit at 0.75. GB couldn’t monetize the whole 1million USD paper profit, but still manages to make 800K on the deal and decides to take well deserved holidays on a tropical island.
- At the same time, the market observers don’t understand whats going on, why pUSD loses its peg. SNS talk about FUD and manipulation and irrationality of the market. the arbitrage traders who try to make profit on their arbitrage need to sell pUSD to PEG through the conversion and hit the PEGUSD which is spiralling down quickly in a total panic now that GB is not supporting any bid at all. It is difficult to close the arbitrage using the conversion system because the bids on PEG/USD are very sporadic, but some traders think anyway buying pUSD at 0.75 USD on the external exchange is the deal of the year and just decide to wait for the panic to end, so they can unwind pUSD for a profit later.
- The market chaos is bigger than participants imagined. PEG/USD dropped below 0.1USD to new lows at 0.05USD and even pUSD wicked down very briefly to 0.5 on some stop-losses but the panic ended as some new buyers (foolish ?) think they can money knife-catching and it takes some weeks but pUSD finally gets back near 1 and even the PEGUSD price bounces a little bit.
- The confidence in the market is very much eroded as the peg was destroyed for a sustained amount of time but PegNet survived. Many confused traders lost money but the “courageous arbitragers” who bought at pUSD at 0.75 made more than 150k, a handful profit, and are celebrating mocking the bears and those who spread FUD. Even Paul Snow’s millionnaire friend made 10k USD on his trade ( after suffering a 250k paper loss) as pUSD now trades around 1 again.
- GB is back from holidays and cannot believe the market is back to normal…
- RINSE and REPEAT UNTIL THE MARKET GETS IT !!!
Do you think this is a total fiction ? Absolutely not, this is exactly what is going on spot or derivatives markets in traditional markets every time there is some kind of “fixing” to use as a reference price for some other (spot or derivatives transaction).
When the fixing is determined by the state of the market in “normal conditions” for small volume but is referencing much much larger transactions, there is an opportunity for manipulation.
In the case of PegNet, the fixing consists of the conversion rates published by the oracles.
The examples abound, for option expiries for example, where some big traders “defend the strike” to prevent some (binary) options to finish in the money because it costs much less money to defend the strike than they would have to pay out the client.
The Libor scandal is of the same nature as is the Gold and FX fixing scandal. Here is one reference among many others https://www.investopedia.com/articles/forex/031714/how-forex-fix-may-be-rigged.asp
In conclusion, PegNet is a poorly thought project designed by people with little or no financial expertise and that could be easily gamed in the current state of things and I doubt there is any way to escape from this kind of problems by tweaking its design. For their defense, liquidity is not the easiest concept to understand, and for example the fixing arbitrage have gone unnoticed and/or unpunished for years.
PS1. There are other subtleties about the PegNet system worth talking about, notably the important property that FCT tokens are directly convertible to pFCT, but it doesn’t affect much the current discussion.
PS2. Looking into PegNet is making me more curious into looking in real details other DeFI projects such like DAI/MKR or Compound. I intend to research those a bit and perhaps publish about them next. I will also talk more generally about stablecoins in general because I believe the problem with PegNet is not specific to PegNet but a much deeper problem.
