Irecently got into stablecoins and want to learn a bit more about them. The best way to learn is to explain in simple words. So here is me explaining you what I understand from the Lien Whitepaper. Generally I am a fan of easy to understand but clean and focused writing. So all you can expect from this article is to learn what the LienProtocol is, what problem it aims to solve and especially how it is designed to solve that problem.
Part 2 of this article will further elaborate on how Lien’s stablecoin is designed and explain to you how the iDOL minting process, iDOL redemption process and the re- and devaluation of the iDOL work.
If you aren’t familiar with terms like “derivative”, “DeFi” or “smart contract”, just look them up somewhere else on the internet. It is not as difficult as it sounds and you’ll fall down the rabbit hole in no time.
Okay then, let's start.
What is the LienProtocol?
A protocol is a set of rules and procedures, that give a frame for how a system is governed/operated. Like in chess where each player has their own strategy but can only move each figure as dictated by the rules/protocol of chess. In Cryptoeconomics, a protocol consists of algorithmic code that provides the frame of what's possible and not possible for an individual to do within that protocol. The cool thing about protocols is, that from time to time some clever person builds a construct of rules, which if everybody acts according to those same rules is very advantageous for each individual. For example, the rules of a state, laws, tell us not to drive drunk. If we all behave accordingly, the state's protocol creates a better situation in which no one drives drunk as one in which we all risk ours and other people's lives.
So in that sense, the LienProtocol is the underlying set of rules, that tell the user of that protocol what can and can't be done within the system. If behaving accordingly to these rules, this protocol will eventually provide its users with a new and more efficient way to hedge against or take the risk of cryptocurrency markets while introducing a new and likewise more efficient stablecoin.
Also, the LienProtocol is part of Lien, a DeFi platform. Next to the protocol, this platform will eventually include a Dex to provide liquidity for several kinds of derivative tokens and their native stablecoin iDOL.
Lien’s developer team is completely anonymous. They say: “We are not a team; rather, we are a protocol”, leaving me to guess that they are either a scam (sorry to sound so harsh but we all gotta be careful after so many previous scams) or want to provide a complete automatically running system in which no human is required after the system is up and running. Not going public with their identities would support that non-human centered vibe and would make an exit far easier.
The problem, the Lien project solves:
- First of all, they want to tackle cryptocurrencies' main problem of unreliable/too volatile values by implementing a stablecoin. A coin that is pegged to a certain USD value and does not fluctuate too much. If a protocol could create such a stablecoin of which 1 unit is worth as much today as in 2 years, it could finally serve us as fiat money does today but at the same time bring all the advantages of cryptocurrencies to the people.
- If you didn’t know yet, many protocols (>50) have already created such a stable coin through many different schemes. Off of these, MakerDAO created the most widely used stablecoin DAI.
- However, a system like Maker depends on its MKR holders to adjust/determine the stability fee which controls supply and demand for DAI. Hence the supply and demand are adjusted through human intervention rather than automatically, and there is no good algorithm for automatic price stabilization implemented in the protocol.
- Also, do such systems require over-collateralization (deposit 150$ in ETH as collateral and only receive 100$ in a DAI loan so that 50$ serve as a buffer in case the ETH value drops and your collateral is to be liquidated).
The LienProtocol however, provides a new stablecoin called iDOL (independent Dollar) whos price is algorithmically stabilized without human intervention. Also, does its design make over-collateralization redundant and additionally allows for using the collateral within the system in a manner that is roughly twice as efficient as MakerDAO. Lastly, it gives you the additional opportunity to make use of so-called immortal options which are Ethereum based options (call options, at the money call options, capped leveraged options or customized options) without margin calls or liquidation.
How does the LienProtocol achieve these things?
In this section, I took anything that is available on the LienProject and tried to explain it as easy to understand as possible. It is mostly based on the Lien Whitepaper and includes quite a bit of their formulations and graphics. So credits to them!
At the very core, the Lien team makes the assumption, that we live in a Pareto inefficient crypto economy in which participants are either risk takers that want to be exposed to price volatility or risk hedgers that would only like to use cryptocurrencies if the price was stable. In their opinion, a new set of rules (protocol) could make use of these two states and create a more efficient situation. The LienProtocol is therefore designed in a way, that has the risk-takers insure the price volatility risk through a derivative contract, which risk-hedgers can buy to minimize that same risk. Basically, the protocol minimizes the risk of volatility by having speculators insure the risk.
First Idea:
You, an individual in the DeFi space deposit Q=1 ETH into a smart contract which will immediately return you the same value of 1 ETH in the form of two derivative tokens. One is called a Solid Bond Token (SBT) and the other is called a Liquid Bond Token (LBT).
The protocol is designed in a way in which the LBT token will take on all the price volatility risk of the 1 ETH so that SBT is almost not exposed to that risk and can be assumed to be almost stable.
While the LBT will be traded as a class of liquid speculative assets, the protocol creates a basket of SBT’s to back a new stablecoin called iDOL. Because the iDOL is backed by an already extremely stable asset (SBT) and not by using price-volatile Ether or BAT as collateral, the risk of sudden collateral devaluation is minimized and no over-collateralization is required.
Summarizing, the value of each SBT remains stable since almost all the price volatility of ETH is taken on by the LBT. In that way, a USD/iDOL exchange rate, which is backed by the almost stable SBT, is kept stable.
Once the system is launched, the price of iDOL will be automatically stabilized around the target level through market forces so that no over-collateralization and no manual adjustment of parameters through an equivalent of the Stability fee is required to maintain a stable value.
Variables you should keep in mind:
- Q: Q ETH is deposited into a smart contract which will give out two derivative tokens (SBT and LBT)
- K: We peg Value of SBT to K USD
- P0: USD/ETH exchange rate (price of ETH in USD) on the issuance date t0
- P1: USD/ETH exchange rate (price of ETH in USD) on the maturity date M
- t0: Issuance date of the derivative
- M: Maturity date of derivative
Step 1: Designing SBT and LBT derivatives:
Ideally, a stable coins value should be completely insensitive to the fluctuation of the USD/ETH exchange rate:
Therefore the project's goal is to construct a derivative token whos value = its return on maturity date M replicates the value of the ideal stable coin depicted above. This is how they do it:
By holding any amount of ETH (valued in USD), the holder is exposed to potential loses or profits if the value of ETH in USD de- or increases. The potential profits that are gained in case of an increase can be displayed on a 45-degree line:
So, one deposits Q ETH in a smart contract which will return us the STB and the LBT tokens. P1 is the USD/ETH exchange rate (price of Ether in USD) on the derivatives maturity date M.
The protocol will also peg the value of SBT to K USD. A proxy for the peg will be provided by a reliable oracle (e.g. ChainLink)
The logic behind this:
On maturity date M of the derivative, the derivative (= the smart contract that it is based on) returns the smaller amount out of
- K/P1 ETH (=K USD) and
- Q ETH
to the SBT holder. The rest of the deposited Q is returned to the LBT holder:
- Q ETH − K/P1 ETH or
- Q ETH − Q ETH = 0 ETH
This means that only if K and Q are chosen in such a way, that
- Q ≥ K/P0 or P0 ≥ K/Q in t0,
the SBT holder will receive K/P1 ETH = K USD.
In other words: Only then will the SBT holder receive K in t1 with high probability, making the SBT worth K.
This lets risk-hedgers hedge against ETH’s price volatility since holding ETH is converted into holding SBT (and LBT but one can sell that token), which will pay out a fixed value K to its holder in t1 and therefore can be called stable against the USD.
Risk-takers, on the other hand, can speculate on ETH’s value through holding LBT. They do hereby take on all the risk if P > K/Q and LBT’s value becomes zero when P is < K/Q. They can also engage in leveraged trading by holding LBTs. In that case, unlike leveraging through debt-finance, they do not have to provide collateral to conduct the leveraged transaction. Hence, there is no margin call and liquidation even if P falls dramatically.
Example:
- Price of Ether right now is P0 = 200 USD/ETH
- I deposit Q= 1 ETH to the smart contract and want to receive 1 ETH = 200 USD/ETH on the maturity date M
- K = $100
- The smart contract will divide the 1ETH into SBT and LBT whos holders receive a payout based on the price P1 of ETH on the maturity date M.
- The same person could be holding both SBT and LBT, sell both or sell just one.
The smart contract does now say:
- The holder of the SBT will receive the entire 1 ETH if the ETH price
P1 ≤ $K upon maturity.
In that case, the SBT holder would receive 1 ETH = P1 USD while the LBT holder gets $0. - If P1 > $K upon maturity, the holder of the SBT gets ($K/$P1) ETH and the holder of LBT will get Q ETH–($K/$P1) ETH.
In that case, the SBT holder would receive ($100/$250) ETH = 0,4 ETH = $100 USD = K, while the LBT holder gets 1 ETH−($100/$200) ETH = 0,6 ETH = $150 USD. - The total amount of ETH that both Tokens pay off will always equate to Q ETH regardless of the P1 on the maturity date.
Imagine you decide to sell your SBT but hold the LBT after depositing the 1 ETH. Since P0 was $200 when they were created, the value of the SBT will be slightly lower than $100 and the value of LBT will be slightly above $100, with both tokens totaling $200. The SBT will be valued at a slightly lower price than $100 because its maximal payout amount will be $100. If we assumed that you sold your SBT at $99, then the LBT you are holding now is worth $101. That is the same as if you have paid $101 for an LBT token.
This LBT token could now also be used as a leverage token
- Say P0 = $200 and doubled to P1 at $400. If you had held on to the 1 ETH, your investment of initially $200 would have made you an extra $200.
- Instead, if you just would have bought the LBT token by taking half of your investment ($101 to buy the LBT) and the ETH price reached $400, you would have gained $300 (Q ETH − ($K/$P1) ETH =
1ETH − ($100/$400) ETH = 0,75 ETH x $400 USD/ETH = $300 or easier: $P1 − $K = $400 −$100 = $300) → 3x leverage!
Another very cool feature is, that LBT can be divided into several tranches. Through this feature, the protocol gives you the ability to create options in any way you want and then take advantage of the price development of ETH as effectively as possible. Examples would be call options, at the money call options, capped leveraged options or customized options.
A problem that cannot be eliminated:
Even if K/Q is chosen much lower than P0, P could drop dramatically so that P0 could become lower than K/Q so that SBT is no longer pegged to K USD.
In that case, it would require the LBT holder to provide an additional deposit to keep the SBT value pegged to K. Since there is no external enforcement scheme that can force the holder to provide this deposit the peg would be lost.
Step 2: Construction of stablecoin iDOL
The second step to achieve the LienProtocol’s goals is the creation of a new stablecoin.
This stablecoin will be backed by the value of the SBT token. Because SBT will be used as collateral and because its value is already stable, the protocol does not need over-collateralization (also see: “The problem, the Lien project solves” in this article).
However, it has to be considered, that SBT has a maturity date. The peg of SBT to K USD will only be maintained until maturity date M, at which the SBT holder is forced to resolve the current position. This is because the LBT holder has agreed to insure the volatility risk only until the maturity date. If SBT holders wanted to keep hedging the risk, they have to either renew the derivative contract or find another counterparty to insure her risk.
Solution: Aggregate many SBTs with different maturity dates so that people can continuously hedge Ether's volatility risk by buying a new SBT when an old one expires.
The stablecoin iDOL imitates this by automatically executing the following procedure:
- Launch a new smart contract (iDOL contract) that holds many SBTs with various maturity dates, Q’s and K’s.
- Create iDOL tokens whose value is backed by the value of SBTs deposited in the contract. Because these SBT tokens have a stable USD value (as long as P0 > K/Q), iDOL tokens created from those SBTs will also be stable in USD terms.
- Unlike SBT that backs iDol, iDol has no maturity date and as long as SBTs are supplied to the iDOL contract, the iDOL holders are assured that its value will be kept stable.
- Anyone can receive a corresponding amount of iDOL tokens from the iDOL contract by “selling” (depositing) SBT to the iDOL contract or “buy” (redeem) SBT with the iDOL token.
How the iDOL minting process, iDOL redemption process with two different auctioning processes and the de- and revaluation of the iDOL work will be explained in the second article called: “The LienProtocol explained (Part2)”.
Wrap up of Part 1:
Now you know how the protocol minimizes the risk of volatility by having speculators insure the risk. If you want further information on how the iDOL token is minted, redeemed, evaluated, de- and reevaluated you should head over to Part 2.
If you got any further questions, catch up with me on Twitter or ask in the comments below.
Also, looking forward to feedback, corrections, comments, and questions anyone may have.
And again: Credits for all the logic and graphics to the Lien project!
