EBTC Builder Series: CDP Stablecoins — Peg Stability Analysis
As the world becomes increasingly digital, cryptocurrencies have emerged as a new asset class that promises to revolutionize the way we transact and store value. Among the many types of cryptocurrencies, stablecoins have gained significant traction due to their ability to maintain a stable value relative to fiat currency or a basket of assets. However, maintaining this peg stability is not always an easy feat. The following article provides a comprehensive analysis of peg stability mechanisms used by some of the most popular Collateral Debt Position (CDP) USD stablecoins and shows how those findings led to the development of a new BTC pegged asset — eBTC. The results shed light on the challenges of maintaining peg stability in the volatile world of cryptocurrencies and provide insights into the design of more robust and reliable solutions.
Soft Peg v.s. Hard Peg
First of all, it is important to define the two types of mechanisms that can be used to introduce stability to a stablecoin’s price: soft and hard peg mechanisms. These can be internal to the CDP system’s architecture or enabled and controlled externally by the issuing authority.
A soft peg mechanism involves the use of a range or band within which the exchange rate can fluctuate. In a soft peg, the issuing authority or internal algorithm responsible for maintaining the peg may use monetary policy tools to intervene if the exchange rate moves too far outside of the range. For example, if a stablecoin is pegged to the US dollar using a soft peg mechanism and the exchange rate moves outside of a range +/- 1% around the peg, the borrowing interest rate may be adjusted manually by the central authority or algorithmically by the system itself to incentivize a specific user behavior that could lead to changes in the asset’s supply and, therefore, its peg.
A hard peg mechanism, on the other hand, involves a strict fixed exchange rate between the stablecoin and the pegged asset. The exchange rate is maintained through direct intervention by the central authority or algorithm responsible for maintaining the peg. If the exchange rate starts to move away from the fixed rate, the authority or algorithm may enable direct minting or burning of the asset at a 1:1 ratio, with the asset being tracked in order to control the stablecoin’s supply through arbitrage opportunities.
Below, the Soft and Hard peg mechanisms of three of the most prominent and innovative CDP Protocols are analyzed in order to get a well rounded idea of the different approaches that industry players have taken to achieve peg stability.
MakerDAO’s CDP stablecoin, DAI, was the first of its kind. It was originally designed to be backed solely by ETH (called SAI in its first iteration) and was later transformed into what it is today; a multi collateral backed asset with several peg stability mechanisms that make it one of the most resilient stablecoins in the market.
Soft Peg Mechanisms
Stability Fees: The floating interest rate charged to DAI borrowers. This fee is different for each collateral type and chosen by MakerDAO governance in order to increase or reduce the borrowing demand to help stabilize the peg.
DAI Savings Rate (DSR): Savings account for DAI where the rate is controlled algorithmically through an Oracle and bound by MakerDAO’s governance. The returns for this product are funded by the stability fee of all positions. When the price of DAI goes below $1, the DSR increases to boost demand and the opposite happens when above peg.
Hard Peg Mechanisms
Peg Stability Module (PSM): A special vault that allows for borrowing DAI (mint) at a 100% collateralization ratio and with 0% Stability Fee. This can be done using governance approved USD-backed stablecoins as collateral only. In the same way, anybody is allowed to redeem DAI (burn) through a PSM for any of these assets on a 1 to 1 basis. Therefore, when DAI is offered above $1, it is profitable to use one of the approved stablecoins to mint it 1 to 1 through the PSM and sell it in the market for a profit until it recovers its peg. A similar dynamic occurs when DAI trades below peg, a profitable arbitraging opportunity surges to buy it “cheap” and redeem it for one of the approved stablecoins. To this date, there have been three PSMs deployed: USDC, GUSD and USDP.
Frax Finance (FRAX)
FRAX, the stablecoin introduced by Frax Finance, was the first to be partially backed by collateral and partially stabilized algorithmically. Until recently, it allowed for 100% backed borrowing, fractionally collateralized by a combination of hard-pegged stablecoins and FXS, the protocol’s governance token.
Soft Peg Mechanisms
Dynamic Collateral Ratio: The protocol adjusts its collateral ratio (CR) algorithmically every hour, in response to market conditions, with changes made in increments of 0.25%. When the price of FRAX is above $1, the CR is reduced, and when it trades below the peg, the CR is increased at the same rate. At any time, a Stablecoin collateral amount proportional to the CR and an FXS amount representing the outstanding collateralization required to achieve 100% can be used to borrow FRAX. At the time of borrowing, the FXS is burned. Essentially, the market’s confidence in the protocol’s level of collateralization is reflected in the price of FRAX.
Hard Peg Mechanisms
Redemptions: FRAX can be minted and redeemed (burned) from the system for $1 of value. This creates automatic arbitrage opportunities when its price fluctuates. When the price of FRAX is above $1, it’s profitable to mint it by putting $1 worth of value (Stablecoins and FXS) into the system and then selling the newly minted FRAX in the market for a gain. The opposite strategy applies when FRAX trades below the peg; buying it off the market and redeeming it 1 to 1 leads to a profitable arbitrage.
Automatic Market Operations (AMOs): A series of governance approved Smart Contracts that can leverage the idle collateral of the system and the minting and burning functions of FRAX to increase the CR and help stabilize the price. These contracts are designed such that their operations can’t reduce the CR or damage the peg. One example is the Curve AMO. It moves idle USDC collateral or newly minted FRAX in and out of the Curve metapool as needed to algorithmically stabilize the price. You can read more on the other AMOs here.
LUSD is a US Dollar pegged stablecoin solely collateralized by ETH. It is minted through a protocol called Liquity, which is interest-free, capital efficient, and immutable. This stablecoin is designed to provide censorship resistance and immutability, which means that it can be borrowed in a trustless manner, and it inherits the decentralization profile from the Ethereum blockchain.
LUSD Peg Mechanisms Diagram (Source)
Soft Peg Mechanisms
Although Liquity’s protocol design does not incorporate any active soft peg mechanisms, there are certain economic and market factors that work in favor of maintaining the peg of LUSD when its price fluctuates between the hard floor and ceiling.
Parity as a Schelling point: LUSD is expected to reach its $1 peg eventually, so any price above $1 creates an incentive to borrow and sell LUSD, making it difficult for the price to sustain above $1.05 for long.
Price ceiling: LUSD has a $1.10 price ceiling, which reduces the profitability of arbitrage trades as the price approaches the ceiling. This decreases buying pressure and may lead to selling pressure if the price hits the ceiling.
Increased leverage as LUSD price rises: Borrowers can achieve higher leverage ratios as the price of LUSD increases, making it more attractive to scale up their positions by minting and selling LUSD. This can push the price down.
Stability Pool vs. LP as the LUSD price rises: As the price of LUSD rises, Stability Pool depositors may shift to a liquidity-providing position, which involves selling LUSD for the pairing asset and pushing the price down. This is profitable since the LP can arbitrage the LUSD price.
Hard Peg Mechanisms
Low Minimum Collateral Ratio: Liquity can offer a minimum collateral ratio (MCR) of 110% due to the liquidation efficiency introduced by the Stability Pool. Therefore, when LUSD trades at or above $1.1, it becomes attractive to mint LUSD at the MCR and sell in the market for an arbitraging profit which introduces a hard price ceiling at this rate.
Redemptions: Liquity allows for 1 to 1 redemptions of LUSD for ETH value at face value as if LUSD was worth $1 regardless of its market price. This means that when LUSD trades below $1, it becomes profitable to buy it off the market at this discount and redeem it for ETH at a $1 value. There is a scaling fee for redeeming that starts at 0.5% and increases proportionally to the usage of this mechanism in order to limit it. Therefore, redemptions introduce a hard peg for LUSD at price floor of $0.995 (0.5% below the price parity).
Historical Performance Comparison
The following graph contains the historical daily average price data (fetched from CoinGecko) of the three CDP Stablecoins analyzed above. On average, FRAX has been more efficient at maintaining its peg around $1 followed closely by DAI and lastly by LUSD. The price variance of the three assets also proved FRAX to be the most stable. Beyond a simple statistical analysis, some particularities can be observed from these results.
From the data collected, DAI struggled to maintain its peg during the first year. It is normal for a Stablecoin to see this kind of volatility during the first weeks or months following launch while liquidity is strengthened. In the case of DAI, this period of volatility was extended, due to the demand generated by COMP farmers at the beginning of the DeFi summer. In fact, this period of extended volatility led to the introduction of the PSM by the MakerDAO governance at the end of January, 2021. Since then, DAI’s peg has held strongly with a variance of 0.000006 as opposed to the 0.00017 measured during the period before.
From the data obtained on FRAX it’s observed that there was an improvement in its peg performance from the beginning of 2022 onward. This improvement could be correlated to the introduction of Frax V2 and the AMOs. Although the first AMOs were introduced mid March of 2021, new additions and improved versions of the most important strategies were developed and enacted throughout the rest of that year. Overall, it can be noted that the hard peg mechanisms that FRAX has in place did an exceptional job at introducing a strong peg for the asset.
Lastly, in analyzing the performance of LUSD, one can note that, although its price variance was considerably higher than its counterparts, it’s hard peg mechanisms worked as designed for the most part. Redemptions enabled a strong price floor with the price of the asset rarely settling below $1. Additionally, the price never reached its hard ceiling. In fact, the soft peg considerations of the Liquity ecosystem led the price to find an average balance between 1% to 2% above the peg.
Impact of USDC Depeg on CDP Stablecoins (March 2023)
Out of all the instances of depeggings witnessed in the three coins, one in particular stands out for its implications. Both DAI and FRAX experienced a simultaneous downward depegging around March 11, 2023, as evidenced by the Peg Performance charts. On this day, both coins hit their all-time-low value at around $0.88, while LUSD’s price remained slightly above the peg, as usual. In the following analysis, the events leading up to this major depegging for DAI and FRAX and why LUSD was able to withstand it are explored.
This report notes that the introduction of the PSM was instrumental in achieving the improved peg stability that DAI has enjoyed since the beginning of 2021. However, as a by-product, DAI has become primarily collateralized on a 1-to-1 basis by USDC, one of the largest centralized US Dollar Stablecoins in the market. As the date of the spike approached, there were approximately 2 billion USDC deposited in the PSM, representing around 40% of DAI’s total collateral value at the time.
Coincidentally, USDC was also Frax’s asset of choice to back the collateralized portion of the FRAX stablecoin. This means that FRAX is always partially collateralized by USDC, according to its CR. Furthermore, the Frax community recently approved a proposal to modify FRAX’s mechanics so that its CR gradually moves to 100% over time, completely removing the algorithmic component of the system (in response to Terra UST and the increased regulatory scrutiny around algorithmic stablecoins). As a result, FRAX became almost entirely collateralized by USDC shortly thereafter.
On March 11, 2023, the market received a surprise when news broke that there was a possibility of partial insolvency for USDC. This was due to the crash of one of the banks that held a portion of its reserves (See article). The market quickly reacted to this news, resulting in a 12% drop in the price of USDC. Since DAI and FRAX were mostly collateralized with USDC, they were affected by this negative sentiment, resulting in a simultaneous depegging. However, LUSD was not impacted by this event as it is solely backed by ETH. In fact, quite the opposite occurred, as LUSD experienced an increase in demand. Many market participants viewed LUSD as a hedge against risks associated with centralized stablecoins.
In conclusion, designing a CDP based Stablecoin that can effectively maintain its peg is not an easy endeavor. All of the mechanisms analyzed above have proven to have strengths and weaknesses. The hard peg mechanisms introduced by FRAX and DAI were very effective at maintaining peg for their coins but they did so at the expense of becoming collateralized primarily by a centralized stablecoin which, as a result, increased their centralization profile and exposed the assets to a new series of risks. On the other hand, Liquity sacrificed a tighter price ceiling for decentralization and censorship resistance.
How does this apply to eBTC?
With eBTC, the goal is to create a financial primitive that can withstand the test of time while embodying the principles of censorship resistance and decentralization.
In order to build a product that adheres to these principles, careful consideration on how to introduce sufficient peg stability mechanics without compromising on core values was taken. By looking at every aspect of a CDP system from the ground up, and by analyzing the top performing models currently in the market, it’s believed that eBTC, as it currently stands, can introduce a model with limited compromisation and a clear path toward further decentralization.
As mentioned in the latest eBTC Builder Update, Liquity’s LUSD architecture stood out as an exception among other models. It not only excels at providing censorship-resistant and capital efficient borrowing but, with open redemptions, it allows for effective price floor arbitraging. For these reasons, borrowing from this model as inspiration for eBTC in its current state was utilized.
Soft Peg Mechanisms
Similar to LUSD, eBTC does not incorporate any active soft peg mechanisms within its core design. However, certain external economic and market factors are in place to ensure that the peg is maintained when the price of eBTC fluctuates between its hard floor and ceiling.
Price ceiling: eBTC has a 1BTC x MCR price ceiling, which reduces the profitability of arbitrage trades as the price approaches the ceiling. This decreases buy pressure and may lead to sell pressure if the price hits the ceiling.
Optimized leverage: As the underlying Liquid Staking Derivatives that collateralize each CDP continue to earn yield, there is incentive to leverage up on eBTC. This results in significant sell pressure on the asset due to two factors. Firstly, there is no upfront fee for the collateral, increasing the capital efficiency of each loop. Secondly, each fold amplifies the CDP’s collateral exposure and its potential for earning yield.
Sustainability: The eBTC protocol will be sustainable by taking a variable percentage of the yield earned by the underlying LSD collateral. As a result, there will be a greater incentive to pay off the debt of an open CDP within a shorter timeframe to reclaim that yield share percentage. Moreover, the DAO can modify this yield share percentage in governance, within reasonable bounds, to incentivize borrowing or repayment as needed.
Hard Peg Mechanisms
Low Minimum Collateral Ratio and the zero percent fee: The design and implementation of eBTC incorporates a notably low MCR, which has been made possible by the strong correlation in price between ETH Staking Derivatives and BTC. This allowance for a low collateralization ratio, in addition to the lack of an upfront fee, results in a hard price ceiling.
Redemptions: eBTC can be redeemed on a 1 to 1 basis for the equivalent value of LSD collateral at any time. This means that when eBTC trades below 1 BTC, it becomes profitable to buy it off the market at this discount and redeem it for LSD collateral at a parity price. There is a low fee for this operation, therefore, redemptions introduce a hard price floor at this fee percentage below the peg.
Peg Stability Mechanisms as External Layers
While eBTC’s architecture aligns with LUSD, valuable lessons were learned from MakerDAO and Frax’s hard peg mechanisms, which could further strengthen this model in the future. One significant lesson is that a hard peg can only be enforced through mechanisms that have direct access to minting and burning of the assets or the ability to manipulate the underlying collateral. The challenge is to design mechanisms with these capabilities without sacrificing the values mentioned above. Liquity has accomplished this with the redemption system and by introducing a low MCR, but there is still room to innovate on alternatives to tighten the price ceiling. Research will continue in an attempt to solve this.
Rigorous modelling has shown that eBTC’s current hard and soft peg mechanisms should enable the protocol to achieve a reliable peg on its own. However, there is potential to develop versions of the PSM and/or AMOs as external mechanisms built on top of the protocol, rather than as core components. For instance, one could imagine a decentralized product that facilitates managed liquidity and executes efficient arbitrage strategies as a participant in the free market, without requiring direct access to the minting and burning functions. Economic strategies like these could be developed and maintained by eBTC’s stakeholders to help enforce the peg as needed without compromising on decentralization.
Join the conversation…
The research above has highlighted the challenges of designing effective peg stability mechanisms that preserve censorship resistance and decentralization. While the insights found here have been applied to eBTC’s current design, there’s still more work to be done.
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