Algorithmic Stablecoins: The Fool’s Gold of De-Fi?
Why’s a dollar worth a dollar? It may seem like a simple question but there is a whole host of economic theory as to what determines the value of a currency — to explore them fully would be beyond the scope of this paper however most economists agree that the value of a dollar is determined by the demand for dollars, which determined by interest rates set by the Federal Reserve as well as the full faith and credit of the United States Government.[1]
In the decentralized world of crypto-currencies, there is no “central bank” or government agency responsible for maintaining the value of a currency — the first crypto currency Bitcoin, has no such mechanism for maintaining a stable value relative to traditional financial instruments besides a deterministic inflation rate. As a result, changes in demand for Bitcoin results in changes in the price of Bitcoin, which diminishes its utility as a “currency” i.e., as a stable medium of exchange.
Stablecoins 101 — Collateralized Stables
As a result of these shortcomings, the idea of the “stablecoin” was born. Stablecoins, as its name suggests, attempt to maintain the value of the cryptocurrency to an outside currency, usually the US dollar or a basket of currencies.
The most popular stablecoins within the decentralized space currently are Tether, USD Coin and DAI.[2] All three coins are what are known as “collateralized” stablecoins because they collateralize the value of their coins with real assets. In the case of Tether[3] and USD Coin[4], both currencies are backed up by cash or cash equivalents equal to the value of the amount of currency in circulation. DAI uses a slightly different system known as overcollateralization — instead of backing each DAI with a one-to-one ratio of DAI to US dollars, instead what DAI does is allow participants to deposit crypto assets (including other stablecoins) into the MakerDao contract. [5] Participants are then allowed to withdraw DAI as a loan whereby the loan is collateralized by assets worth 150% of the loan’s value. If a user’s assets fall below a certain ratio, MakerDAO will liquidate the borrower’s position and purchase DAI, which is then removed from circulation, maintaining the price of DAI at $1.[6]
Collateralized stable coins work very well — DAI has continued to maintain its peg for over the past three years[7] while both Tether and USD Coin, because of way they operate are locked to 1:1 ratio with the US dollar. Short of some sort of fraud on part of the issuing organizations or credit risk of the underlying cash equivalents, there is little chance that these stablecoins could deviate from their current peg.
Because these stablecoin protocols are either collateralized with traditional fiat currency or require participants to put up collateral in a particular DAO contract, they are unattractive to participants looking for a truly decentralized unit of exchange. A decentralized protocol would avoid third party custodians, therefore making it much more robust against regulations, third party custodial risk and censorship.[8] For many participants within the De-Fi space who have become interested in replicating all financial instruments in a decentralized manner, the inability to replicate what the Federal Reserve does with the US dollar has led for the search in solutions.
Decentralized Stablecoins 101
As a result of these shortcomings in 2014 as well as shortcomings in the two major cryptocurrencies of the time, Ethereum and Bitcoin, two independent researchers Robert Sams and Ferdinando M. Ametrano developed the idea of “algorithmic stablecoins”. An algorithmic stablecoin would maintain its peg to a traditional currency or basket of currency via rules-based interactions with participants.
Both Sams and Ametrano developed slightly different mechanisms for achieving this goal. In Ametrano’s paper he proposed a rule based approach where the value of the currency held itself changes based on changes in demand for the currency[9] i.e. the number of cryptocurrency units in every digital wallet is adjusted based on demand, not the value of each unit.
In Sam’s approach, he proposed a system where the currency would have two token share classes, the currency itself and “seigniorage shares”. Basically, when the currency was below the peg, holders could purchase the seigniorage shares at a discount to the peg, and when the currency returned to being above the peg, the holders of the shares could redeem them for a peg plus a bonus amount of the currency. This would help increase the supply of currency, meaning that the currency would then return to the peg via inflation. In this system, owners of the seigniorage shares would be betting that the currency would return to peg and be rewarded for that bet when it did. [10]
These two approaches have led to the developments of two categories of algorithmic stablecoin. Ametrano’s approach has been adopted by the protocol Ampleforth, while Sams’ approach has been adopted by a variety of teams, most notably Basis Cash, Empty Set Dollar, and Dynamic Set Dollar. Both attempts at achieving a workable currency have not quite been successful, with Ampleforth actually disclaiming the currency label while the seigniorage based currencies have not been able to maintain their peg.
Algorithmic Stablecoins — still a work in progress
Why haven’t algorithmic stablecoins worked in past? In Ampleforth’s case, the token has had high demand and a strong interest from crypto investors.[11] “For a currency to be truly used as a currency, it needs to satisfy all three qualities of money: a unit of account, medium of exchange, and store of value.[12] While Ampleforth satisfies the first condition (as do other traditional cryptos like Bitcoin), it doesn’t quite meet the second and third because of the nature of its rebasement which can change the value drastically compared with traditional fiat currencies. As such, the value of the currency has been fairly volatile around the $1 peg and according to the Ampleforth project its goal has changed — they no longer refer to it as a “stablecoin” but rather a crypto asset uncorrelated with the broader market i.e. a crypto hedge.”[13]
As mentioned, Multiple protocols have attempted to implement Sams’ seigniorage approach without much success. The most notable projects, Basis Cash and Empty Set Dollar, both trade currently at a substantial discount to their peg.[14] There have been two main issues with the currencies, which are self-reinforcing. The first, is that without demand for the coin there is little reason for token holders to believe once these coins dip below their peg, there will be enough demand for seigniorage shares to pump the price back up. The second is without the ability to maintain a price, there is little demand for these products — who would want to hold an asset you think will just decrease in value? In the words of Haseeb Qureshi: “these schemes capitalize on a key insight: a stablecoin is, in the end, a Schelling point. If enough people believe that the system will survive, that belief can lead to a virtuous cycle that ensures its survival.”[15] However, if there isn’t a viable demand, then the stablecoin is doomed to failure and so far these experiments have not been successful.
In light of these experiments, is it even possible to create a truly decentralized stablecoin? Of the two approaches, I believe that the seigniorage shares model is more likely to succeed. Per Sams’ critique:
“Price stability is not only about stabilising the unit-of-account, but also stabilising money’s store-of-value. Hayek money is designed to address the former, not the latter. It merely trades a fixed wallet balance with fluctuating coin price for a fixed coin price with fluctuating wallet balance. The net effect is that the purchasing power of a Hayek Money wallet is just as volatile as a Bitcoin wallet balance.”[16]
As the experience with Ampleforth suggests, this critique is correct and partially the reason why the Ampleforth team no longer is attempting to reach the goal of being a stablecoin.
Can Algorithmic Stablecoins work?
What would an ideal algorithmic stable-coin look like? The first and most important is organic demand for the currency. One issue with both Empty Set Dollar and Basis Cash have been the lack of organic demand for the currency, partially because of the inability to maintain the peg. This has made it unattractive for partners who want to work with the currency and without a reason to use the currency, the lack of demand makes it hard to return to the peg.[17] Secondly the currency would have to have a large enough market cap such that daily currency flows don’t affect the price of the stablecoin. Thirdly, the currency would have to have attractive “tokenomics” such that it was attractive for seigniorage shares holders to buy and purchase these shares when the token was below peg. Basis Cash has experimented with multiple tokenomics schemes[18] but its inability to return to peg shows that this is not an easy formula to find.
I believe that a hybrid model of stablecoin could be a model for future success. An algorithmic stablecoin partially collateralized with other crypto-assets could potentially bridge the gap between when the currency was first launched and when the currency actually had organic demand and faith among its users that it would maintain its share price. The newly released FRAX token is an attempt to bridge these two models by partially collateralizing the currency while still using an algorithmic system to do most of the work in maintaining the price.[19] While FRAX still has a fairly small market cap of around 120 million[20], it has successfully maintained its peg since its launch, especially compared with purely algorithmic coins like Basis Cash or Empty Set Dollar. Eventually the FRAX’s protocol’s goal is to move to collateralizing less of the currency over time and rely more on the algorithmic component,[21] however ultimately this will depend on whether there is actual market demand for the project and whether the protocol can stay stable in the face of crypto crashes or hacks. Without market demand algorithmic stablecoins of all sorts (even a fairly successful ones like FRAX) could be similar to Hero of Alexandria’s steam engines — interesting, innovative but not practical or useful.
Currencies are not easy things to launch — the US dollar was practically worthless after the American Revolution and took many years to regain its value. The US dollar only started floating freely in 1972 after it no longer became convertible to gold. Similarly, an algorithmic stablecoin could potentially require a period of collateralization and once the three requirements are met i.e., investor faith in its value, large market-cap, and attractive incentives for seigniorage shareholders, the cryptocurrency could sell off its collateralized holdings and float freely as a purely algorithmic stablecoin. While it is unknown if FRAX will pursue this strategy, the current success of FRAX as well as the potential for Basis Cash and Empty Set Dollars to function as truly decentralized money are an exciting experiment within the world of De-Fi.
Links:
[1] Kohn, M. G. (2004). Financial institutions and markets. New York: Oxford University Press. Pg 201.
[2] https://coincodex.com/cryptocurrencies/sector/stablecoins/
[3] https://www.coindesk.com/tether-first-reserve-composition-report-usdt
[4] https://www.centre.io/hubfs/pdfs/attestation/grant-thorton_circle_usdc_reserves20210429.pdf
[5] https://medium.com/mycrypto/what-is-dai-and-how-does-it-work-742d09ba25d6
[6] https://developer.makerdao.com/dai/1/
[7] https://decrypt.co/resources/dai-explained-guide-ethereum-stablecoin
[8] https://medium.com/basis-cash/basis-cash-ecosystem-roadmap-1814d1a4c23b
[9] Ametrano, Ferdinando M., Hayek Money: The Cryptocurrency Price Stability Solution (August 13, 2016).
[10] https://github.com/rmsams/stablecoins/blob/master/paper.pdf
[11] https://coinmarketcap.com/currencies/ampleforth/
[12] https://github.com/rmsams/stablecoins/blob/master/paper.pdf
[13] https://www.ampleforth.org/ampleforth-is-not-a-stablecoin-and-thats-ok/
[14] https://cointelegraph.com/news/algorithmic-stablecoins-aren-t-really-stable-but-can-the-concept-redeem-itself
[15] https://insights.deribit.com/market-research/stability-elasticity-and-reflexivity-a-deep-dive-into-algorithmic-stablecoins/
[16] https://github.com/rmsams/stablecoins/blob/master/paper.pdf
[17] https://medium.com/basis-cash/realignment-of-inflation-incentives-917d96548c70
[18] https://medium.com/basis-cash/realignment-of-inflation-incentives-917d96548c70
[19] https://medium.com/coinmonks/frax-a-partially-collateralized-stablecoin-53d7841a4558
