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Empty Set Dollar: A New Hope for Algorithmic Stablecoins

One of the biggest allure of Bitcoin and cryptocurrencies is the explosive growth in price that they provide. However, with this potential comes massive volatility especially compared to traditional financial assets. This is the reason why most people still want to measure their gains in terms of fiat currencies. This has led to the rise of stablecoins, most prominent of which is USD Tether (USDT) and USDC.

What is a stablecoin?

Instead of choosing between traditional and crypto currencies, stablecoins get the best of both worlds. It gets the stability and reliability of real world fiat currencies while also getting transparency, immutability and freedom of cryptocurrencies.

From a relatively small sector, stablecoins have grown to take a big pie in the cryptocurrency world. According to Stablecoinindex.com, as of Dec 2020, the market value of all stablecoins is at 25 Billion. It’s crazy to think that it was only less than seven months ago, in May, that the total marketcap of stablecoins breached the 10 Billion dollar mark. Thats a 150% increase in a few months. Aside from the marketcap, the amount of volume being done through stablecoins as a base pair has drastically increased especially for Futures and Margin trading. For example, Tether which has a marketcap of 19 Billion is doing over 40 Billion in daily volume. Compare this to Bitcoin which has a marketcap of 350 Billion but is only trading 25 Billion daily. It is an understatement to say that Stablecoins have become an essential part of the ecosystem.

There are currently multiple types of stablecoins: Fiat backed Stablecoins, Crypto/Asset backed stablecoins, and algorithmic stablecoins.

Fiat Backed Stablecoins

This type of stablecoin is the most popular. Fiat backed stablecoins are backed 1:1 with fiat currencies. This means that for every 1 USDT that is minted and in circulation, there is an equivalent amount of USD held by the issuing company. This gives people confidence especially arbitrageurs since they can redeem an equivalent amount in USD as offered by the company.

On the downside, this is very capital inefficient since the growth is based on the amount of fiat the company has. Since these companies are all private, the community gains no exposure to the possible upside and profits are all kept within the company. This centralization also gives them the power to blacklist addresses, a power that could be devastating if it falls into the wrong hands.

Right now, this type of stablecoin dominates the stablecoin industry in terms of marketshare particularly because it has been tested and is easy to understand. Most of these companies allow you to exchange your USD pegged stablecoins for actual USD. Primary examples of fiat backed stablecoins are USDT, USDC and TUSD.

Asset backed Stablecoins

This is the second most common type of stablecoin. Assets can range from traditional assets such as gold or other cryptocurrencies such as Bitcoin or Ethereum. There are also examples of Electricity being used (e.g. Meter.io) or basket of currencies (e.g. RSV or Libra). Since the underlying assets used as collateral are volatile themselves especially for the crypto assets, they require overcollateralization making it even more capital inefficient. On the plus side, it does give stagnant assets a way to generate some sort of revenue.

Algorithmic Stablecoins

The last and the focus of this review are algorithmic stablecoins. These stablecoins are not backed by anything. (sidenote: The dollar itself is also not backed by anything but the trust in the government). It may sound counterintuitive, but it uses a game theory approach to achieve the desired stable value. Among the three types above, this is the most experimental.

The most famous example is Ampleforth which uses a rebasing mechanism to achieve a target price. When the price goes above the target of 1$, more supply is added to the market directly to the holder and also proportionally. This increase sell pressure. When it goes below $1 the opposite happens. AMPL holders sometimes wake up to less having less AMPL tokens as the value goes below $1. This can lead to a death spiral causing even more volatitiy with the stablecoin. The mini DeFi pump of August 2020 showcased Ampleforth’s flaw wherein there were days when the price of AMPL shot up above $2 because people were getting more and more of it as the price increased causing more people to buy since they are thinking of it as yield. As mentioned above, the incentives may work in theory but backfired in the real world. Instead of stability, the design brought volatilty.

Empty Set Dollar

Empty Set Dollar (ESD) falls under the algorithmic stablecoin category. It is an elastic supply algorithmic stablecoin. As described above, it is not backed by any asset which makes it an experiment. It uses a game theory approach with economic incentives to achieve its target price.

It borrows concepts from the Basis Stablecoin project. For those not familiar, Basis was a huge stablecoin project that raised millions of dollars of capital in 2018. Despite the backing of prominent venture firms (e.g. Bain Capital Ventures, Andreesen Horowitz) and personalities (e.g. one-time Federal Reserve governor Kevin Warsh), they were shutdown in late 2018 after operating for about a year. They ended up returning investors’ money blaming regulatory constraints as the main reason of the shutdown. On hindsight, it was a horrible idea to ask for permission from those in charge of the dollar which they were directly competing against.

Unlike Basis, ESD’s team is pseudonymous. This mitigates the regulatory risk similar to how Bitcoin was also created by the pseudonymous Satoshi Nakamoto. What’s most impressive is that the team did this without any fundraising. Despite both of these aspects, ESD has managed to gain a large following, a proactive community and a sizeable marketcap of more than 100 million dollars after just being operational for 4 months.

How ESD works

For stablecoins there are 3 states that it can achieve. In the case of USD stablecoins its =$1, <$1 and >$1.

State 1: ESD is = $1

Great! It has achieved its goal of being a stable coin. But as with any market, this will not not be fixed because of the constantly changing demand and supply. And the fact that it is being used means that its value will shift as you buy or sell into it.

State 2: ESD trading above >$1

When ESD rises above $1, the solution is straightforward, more ESD is minted and issued. Unlike in AMPLs case where it is sent to all token holders, newly minted ESD is used as an incentive (meaning it is optional for holders to partake which has its own risks and rewards).

Newly minted ESD is sent to those that have bonded their ESD or have provided to the ESD liquidity pool on Uniswap. This creates a natural sell pressure which will push the market price down to $1. As a form of hierarchy, coupons and debts have to be paid off first before being rewarded to those that staked or bonded.

ESD also uses a TWAP (time weighted average price) on its token price on uniswap over an 8 hour period (also called an epoch). This makes it incredibly expensive for those that want to exploit the system using flash loans.

ESD is trading <$1

ESD introduces the concept of “Coupons”. Users can obtain coupons by burning ESD. In turn, these coupons are priced at a discount to ESD. They represent a claim on future ESD tokens minted. They act as call options with a strike price of >$1. They are only in the money, in options trading lingo, only if the price reaches greater than $1. Meaning that it will be worthless if it does not go above $1 in 30 days. It does carry a risk given its 240 epoch (30 day) expiry.

The coupons themselves do not directly affect the price. However, those that bought these coupons are incentivized to keep price above 1 especially towards the end of their date. This makes coupons, such as options trading, much riskier if you do not understand the mechanics. But the rewards can be lucrative too as seen in the example below.

This mechanism is wonderful in two ways. In the initial phase, where liquidity is being bootstrapped, bigger players that can move the market will be able to carry the load and make sure ESD goes above $1. Later on, as more liquidity is in the market, the collective effort and game theory kicks in, rewarding people to push price up when ESD is below $1 and vice versa.

Example with Numbers:

ESD is trading at 99 cents. Coupons are currently at a 10% discount with an implied value of 90 cents. A trader burns 1 ESD to get 1.1 coupons (0.99/0.90). This means that once ESD reaches a $1 price, the trader has turned his 99 cents to $1.1 implying a 11.11% gross profit. IF ESD trades at a higher than $1 price, then he will have even more USD worth of ESD making his profit even greater.

Conclusion

ESD is a new and innovative approach to algorithmic stablecoins. It approach the pegging problem from a new perspective with new incentives for players. As with most things, only time will tell. How this performs during periods of extreme volatility like during an alt season will show if this experiment has failed or succeeded. The past month’s data shows that it is slowly getting there with prive hovering above and below the dollar mark most of the time.

One thing to like about ESD is its active community. It is no longer solely on the hands of the main contributors but rather, the community is getting more involved in shaping the future of the Stablecoin.

Helpful Resources:
Mega Twitter Thread: https://twitter.com/Rewkang/status/1331358587197669378
Spotify podcast:
https://open.spotify.com/show/6dxJSX3ARomu1RB0IjNFGh?si=gJtc8LhKTrWZMY7o3SvA7g
Bankless Interview Dan Elitzer about ESD:
https://www.youtube.com/watch?v=X550gZZmrsA&t=2371s

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