Not so stablecoin and the inflation hedge — An evolution of the crypto monetary system
Dont want to read? TLDR here
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US CPI soared by by 8.5% the highest annual increase since Dec 1981. This of course does not take into account “transitory inflation”. However when does “transitory inflation” become “persistent”? and as a consumer, do I really care if it’s “transitory”? In the words of John Maynard Keynes “In the long run we are all dead.” To the consumer, “transitory inflation” may as well be permanent, we care that prices are high now not that the problem will go away in 6 months.
The question then becomes, how stable are stablecoins and how can we really tackle inflation? Before we discuss this, let’s dive a little bit into how our current monetary system has evolved over time.
Evolution of the monetary system
Hard money system — Monetary system based on items with intrinsic value, typically gold, silver and copper coins. No trust required on any party.
Claims on hard money — Hard money replaced by IOU notes for convenience. These can be exchanged for its value in underlying gold or reserve asset.
Credit system begins to explode, lending and borrowing explodes, now there are more IOU notes than the value underlying assets to redeemable.
Fiat money — Banks realize that under collateralization makes pegging to the value of gold and shift to a fiat system (The US moved away from the “gold standard” in 1972). Value of fiat money is now determined based on a trust in the system and the use of monetary policy tools.
Stablecoin, Shmablecoin
As hard as crypto natives try to get away from the existing financial and monetary system, one could say that the very same experiments which brought to life the latter are taking place right now on the blockchain. The same can be said about the Crypto monetary system which can be classified as follows.
Hard money system — $BTC, $ETH
Claims on hard money (overcollateralized stables) — $DAI, $MIM
Fiat money (algo stables) — $UST, $FRAX, $BEAN (RIP)
Going back to our existing monetary system, fiat currencies like the US dollar today can be seen to be “loosely pegged” to a basket of goods, in that the Fed targets an inflation rate of 2%, effectively ensuring that the “value” or purchasing power of the dollar does not fall too far away. Stablecoins today mimic the same system by maintaining their peg to the US dollar.
Stablecoin 2.0
Enter Stablecoin 2.0 with Frax Finance and Volt Protocol who have brought to market their respective inflation resistant stablecoins by sourcing their inflation data from monthly reports issued by the Bureau of Labor Statistics using Chainlink oracles.
By combining stablecoin liquidity and purchasing power protection of Inflation-Linked-Bonds, these new innovations are the next evolution of the existing stablecoin landscape.
Let’s dive in.
Frax Finance — $FPI and $FPIS
Frax Price Index $FPI — inflation pegged undercollateralized stablecoin
Frax Price Index Share $FPIS — governance token
The $FPI treasury will initially be backed by $FRAX with a transition to expand into other crypto native assets and non-crypto consumer goods and services. While there is little news on what the non-crypto strategies are, having this in place signals a long awaited future where the line between crypto and non crypto blur.
Maintaining the peg
As an undercollateralized stablecoin, the $FPI peg works similarly to the $FRAX peg which is supported through treasury yields. Excess yields are directed to directed to $FPIS holders, similar to $FXS. In the event this is insufficient to support the peg, new $FPIS will be minted and sold to increase the treasury.
In short:
Treasury Yield > Inflation = $FPIS holders win
Treasury Yield < Inflation = $FPIS holders lose
Additionally, in deflationary periods, the yields will be fully directed to $FPIS holders.
The question anons have is whether the peg can be maintained sustainably. Think about this for a second… How are yields on TIPS derived? — By exercising the underlying treasury on real-world assets. Unless we can successfully make the argument that real-world assets are generating more yields than crypto assets, this argument quickly falls apart.
In the short to medium term, crypto yields will likely remain much higher than that of real-world assets because of risk-adjusted returns, demand for liquidity (protocol liquidity incentivization), and just the sheer number of yield-bearing strategies within crypto. Anon, don’t forget the sheer efficiencies of cutting out middlemen and reducing operating costs, Yuga Lab's net profit margin was reported to be >90%. Given Frax Finance is looking to incorporate other crypto assets as well as real-world assets outside of $FRAX, translating into a multitude of levers to exploit vs purely real-world asset-backed TIPS.
The next question is then…What about under collateralization? Well anon, Frax Finance makes more money per $1 in circulation than MakerDAO and Circle combined. So if you think under collateralization is a barrier, you are in for a shock. What’s really important is how successful Frax Finance has been in maintaining the peg for $FRAX. At 24:11 Sam Kazemian explains how $FRAX has never broken the peg (1 cent threshold) even once on-chain.
Check out these stats below:
Anon 3.92% on veFXS from pure yield-bearing strategies, all organic, no token emissions.
- MakerDAO: $0.0076 in revenue per $1 in circulation
- Circle: $0.0015 in revenue per $1 in circulation
- Frax Finance: $0.0888 in revenue per $1 in circulation.
Direct quote from Sam Kazemian at 55:23 that $FRAX has $2.7bn supply but makes $200m in revenue. That's about $0.0741 of revenue per $1 supply. Just think about it.
Volt Protocol — $VOLT and $VCON
$VOLT — inflation pegged overcollateralized stablecoin
$VCON — governance token
$VOLT can be obtained by a) exchanging with $FEI stablecoin b) minting by over collateralizing assets on Fuse pools.
Maintaining the peg
$VOLT subscribes to the over-collateralization model similar to $DAI, favoring a large treasury to build up surplus yields and reserves. This additional room for $VOLT to maintain its peg even reserves aren’t being actively deployed.
In the Frax Finance model, $FPIS is minted when yield < inflation to support treasury. Kirk Hutchison makes the argument that this will in effect reduce liquidity as $FPIS is sold when the price is low (because yields < inflation) and bought back when the price is high (because yield > inflation). The benefit to holders, however, is clear as the upside is magnified when yields are high and $FPIS supply is low.
Volt Protocol seeks to do the opposite by selling $VCON when yield > inflation to shore up the treasury and buying back when yield < inflation. While this makes sense from a protocol standpoint, it is unclear how the tokenomics will play out for $VCON holders. Minting more $VCON during periods of high yield could benefit holders provided yields are successfully captured. Failure to do so, however, translates to the downside for $VCON holders due to an increase in token supply as yields remain flat.
Note that this is largely my speculation as details on $VCON tokenomics are still unclear as we await more information from the team.
Thoughts on the yin and yang of inflation resistant stablecoins
It is obvious that while both Frax Finance and Volt Protocol are trying to achieve a similar goal, the approaches are like yin and yang. As such while the $FPIS mechanism could potentially lead to thinning of the treasury, this is probably less of a concern for an algorithmic stablecoin that is seeking to continuously reduce its collateralization ratio.
Furthermore, it will be interesting to see if over-collateralization is really the right approach, sure the peg will in theory be more secure but at what cost? Given that much of DeFi, today has been around liquidity optimization, it is hard to say that $VOLT > $FPI is based on the success of Frax Protocol in defending the $FRAX peg.
At this point, my bias for under collateralization is probably oozing out. While I do have a preference, it is by no means a dump on Volt Protocol. There is still information yet to be released with respect to $VCON and it is frankly too soon to know how the respective structures will play out.
Why should you care?
In simple terms consider how this would be a game-changer for the mass market. In Tradfi, the only option for something akin to an inflation tracking stable are inflation-linked bonds which you can’t spend like you would fiat money. The inflation-resistant stablecoin introduces the best of both worlds: inflation hedge + stables liquidity. This means that you can be hedged against inflation while maintaining the option to trade into other assets whenever you want.
Given the core ethos of crypto is to move away from the tyranny and risk of centralization, the expansion of both Frax Finance and Volt Protocol are key to censorship resistance. Unlike $USDC or $USDT, both are fully decentralized and backed by on-chain assets, which lends itself to a more equitable approach to governance and creative exploration of its uses.
As mentioned previously Frax Finance and Volt Protocol have plans to expand into being backed by real-world assets. While I have tooted the higher returns of crypto assets, being able to tap into real-world assets means the ability to deliver more sustainable sources of income and not just emission-based yields from other staking protocols. While too soon to say, perhaps there is an aspiration to be a DeFi-led bridge (as opposed to $USDC/$USDT) between the crypto world and the non-crypto world. IMAJIN, spending $FPI and $VOLT in the real world.
Finally, it has also been mentioned that the existing BLS CPI peg is just the beginning. Given that current CPI data could be considered curated or cherry-picked by the government, being able to move away from this means delivering a truer hedge against inflation. By pegging towards a community-selected basket of goods, could it be possible that the DeFi world will take the lead in pushing the evolutionary possibilities of what a new inflation hedge could look like?
