An Early Look at Celo: Part 2
Celo is a mobile-first solution that’s composed of three main elements: lightweight identity and an ultralight client, a stability mechanism for stable-value currencies, and a governance system with incentives to ensure platform stability. In Part 1 of our Early Look at Celo series we explored what lightweight identity means for Celo and how it works. For Part 2, Justin Gregorius from CoinList recently spoke with Markus Franke, a Partner at cLabs, about their stability mechanism and token economics.
Justin Gregorius: Thanks for speaking with us, Markus. To start, Celo has two digital assets that are native to the protocol: Celo Gold (cGLD) and Celo Dollar (cUSD). How are these tokens different?
Markus Franke: Celo is a decentralized platform that can host a whole family of stable value assets. cUSD is the first of hopefully many different elastic-supply stable value assets and its value tracks the value of, as the names suggest, the US Dollar. Similar to ETH on the Ethereum platform, cGLD is the utility token used to participate in the Celo ecosystem. It is a fixed supply variable-value asset and its utility is linked, in part, to the demand of cUSD as cGLD is part of the stability mechanism and the reserve.
JG: Diving into that stability function a bit more, Celo maintains the value of the Celo Dollar with a mechanism that algorithmically contracts and expands the supply of cUSD. Can you explain the stability mechanism in more detail and the role that Celo Gold plays in it?
MF: The stability mechanism can be understood as a hybrid crypto-collateralization and seigniorage-style model. To maintain the stability of cUSD, the protocol sets incentives for users to adjust cUSD supply to match cUSD demand at the price peg. At a high level, the Celo expansion and contraction mechanism allows users to create new cUSD by sending 1 US Dollar worth of cGLD to the reserve, or to burn cUSD by redeeming them for 1 US Dollar worth of cGLD. This mechanism creates incentives such that when demand for cUSD rises users are incentivized to buy 1 US Dollar worth of cGLD on the market, exchange it with the protocol for one cUSD and then sell that cUSD for the market price (Expansion Cycle in below numerical example). This direct link between cUSD and cGLD is driving the market price of cUSD back towards 1 US Dollar without the need for the protocol to estimate the optimal expansion or contraction amounts. Having a crypto-only reserve allows for this process to be running constantly and transparently.
JG: The crypto-only reserve is really fascinating, especially because cGLD is not the only crypto asset in the protocol reserves. What other assets are held in reserve? How does the process of buying and selling those assets compare to the buying and selling cGLD?
MF: The protocol reserve consists of blockchain assets, for the reserve to adjust constantly and for the holding of these assets to be fully transparent to the stakeholders and community. Along with cGLD the initial reserve will also hold other decentralized assets, like BTC and ETH and less volatile assets on a blockchain. As more assets are tokenized in the future, the mechanism allows for the reserves to also include real assets, and you could also imagine tokenized forestland or other natural-capital. The reserve is periodically rebalanced to achieve a target ratio of cGLD and non-Gold assets. For the first version of the reserve, trades have to be executed at more centralized exchanges, also for liquidity reasons. Different teams are working on bridges across the chains in the reserve to even more fully decentralize the reserve mechanism.
JG: We’ve talked about how the Celo maintains the peg for stablecoins issued on the protocol, but what are the risks associated with the stability mechanism?
MF: In order to better understand the risks associated with this decentralized system, the cLabs team, with input from the larger community, has done extensive statistical modeling and simulating. The state of this research can be read in the “Analysis of the Stability Characteristics of Celo”. While the protocol consists of several ways to protect against this scenario, the primary risk to stability is still a scenario in which there is a contraction in demand for cUSD greater than the total value of the reserve. This means that it is critical for the reserve to maintain adequate value to handle sharp contractions in demand for the supported stablecoins. To bolster the reserve the expansion and contraction mechanism contains a spread, a small fee that is paid for every transaction within that mechanism. When the reserve ratio is below a certain threshold, a fraction of the block rewards (called epoch rewards) is distributed to the reserve. In times of a low reserve ratio, a variable transfer fee on cGLD transactions will also help to further bolster the reserve.
JG: Back to cGLD’s role in maintaining stability, the protocol encourages long term holding of cGLD by instituting a variable rate transfer fee. Can you explain how this fee works and why it is important to maintain the value of cUSD?
MF: Yes, the transfer fee is an important part of the stability mechanism and is paid on all transactions involving cGLD during times in which the reserve ratio is below a threshold, and thus encourages long-term holding of cGLD. All proceeds from this fee go to the reserve. The fee can be adjusted dynamically as a function of the reserve ratio to generate higher reserve inflows when the reserve ratio is low, or at any time through the full on-chain governance supported by the fully decentralized platform.
JG: Beyond cUSD, Celo allows for additional stablecoins to be issued on top of the protocol to encourage the development of a robust monetary ecosystem. How will additional stablecoins be issued on the protocol?
MF: A family of local, regional, and utility stable value coins in addition to the cUSD would make the overall protocol more robust and increase the stability characteristics of each asset in the family. Additional stable assets can be introduced through on-chain governance. Every cGLD holder can take part in governance, cGLD aligns incentives of stakeholders in this proof-of-stake consensus and governance model. cGLD holders are incentivized to participate in on-chain governance and to make decisions that keep the long term health of the network in focus. In this process, stakeholders can propose ways to improve the network, for example, introducing additional stablecoins. Once changes are proposed, cGLD holders vote on whether or not to implement the proposal.
JG: For the stablecoins issued on the protocol, Celo’s documentation outlines this concept of a shared reserve. Can you explain this concept in more detail and provide an example of how it will work?
MF: Importantly, this is a potential future state dependent on on-chain governance and the decisions of cGLD holders. A family of different stablecoins will increase the stability characteristics of each of the stablecoins via a shared reserve and the same expansion and contraction mechanism via cGLD. When the protocol introduces a new stable value coin the reserves for that asset are the same reserves for cUSD. Similar to the constant expansion and contraction mechanism, different Celo stable assets can be exchanged with each other. Therefore, f.ex. in times of contraction of one asset, the contraction can be mitigated via the reserve or any other Celo stable asset, the reserve can be disintermediated by the other currency and could be only used if the need for contraction of the one stablecoin is greater than the need for expansion of all the other stablecoins supported by the protocol.
If you’re interested in learning more about Celo, you can visit their website here. If you would like to stay up to date on the upcoming Celo Auction you can register here.
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